Basic Macroeconomics Study Guide Book for Undergraduate

Economics Students

Prepared by: Departments of economics

March, 2023

Debre Berhan University, Ethiopia

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 CHAPTER ONE
THE STATE OF MACROECONOMICS
1.1 What macroeconomics is about?
Economics is divided in to two major branches: Microeconomics and Macroeconomics.
Microeconomics: deals with economic behaviour of an individual decision-making unit (consumer and
producer) or an economic variable (Price and quantity of a good).
Macroeconomics: is the study of the behaviour of the economy as a whole. It concerns the business cycles
that lead to unemployment and inflation, as well as the longer-term trends in output and living standards.
Macroeconomics is a young and imperfect science
 Macroeconomists were not generally successful in predicting the global economic crisis of 2008
 Even after the crisis, they were unable to agree on what should be done to deal with the crisis
1.2 Macro-Economic goals
 Reducing Unemployment (maintaining full employment): employment policy is adopted by
government in order to increase the employment level in the country.
 Price stability: Price and Incomes Policy are adopted aiming at regulating the prices in the market
and also to ensure the minimum wages to the workers.
 Bringing sustainable Rapid economic growth
 Maintaining fair distribution of income
1.3 Macro Policy Instruments
To achieve these macroeconomic goals the policy makers use different policy instruments
Fiscal Policy: concerned with the use of taxes and government expenditures. Government has to meet
various expenditures like salaries, defence expenses, infrastructure development, etc. All these expenses
leave a positive effect on the overall economy.
The other part of the fiscal policy is tax. Taxes are the main source of revenue for any government. Taxes
affect the economy and the individuals in two ways. Reduces the disposable income in the hands of the
consumers this reduces the spending in the economy and the taxes levied on goods and services make them
costlier. This discourages the firm to invest in capital goods.
Monetary Policy: is the most widely used macroeconomic policy instrument. It helps government, managing
the nation‘s money, credit, and banking system. In Ethiopia, National Bank of Ethiopia is the custodian of the
monetary system of the economy. Central bank brings changes in the interest rates, reserve requirements, etc.
These changes make significant impact on the overall functioning of the economy. For example, the
lowering of interest rates on housing loans helped the growth of the housing sector. As a result of low rate of
interest, it became easier to avail a housing loan and to own a house.
1.4 Evolution of macroeconomics
Economic thinking has begun since the cradle of mankind. Keynes pioneered a new approach to
macroeconomics and macroeconomic policy. Any discussion on macroeconomics starts with J M Keynes.
The Mercantilist
They try to explain how growth of an economy achieved based on their observation about situation that
Britain experiences at the time. During 17thand 18th centuries Britain becomes a prosperous nation due to over
sea trade.
When there is balance of trade deficit (M>X) a country pays or spending more on foreign goods than
spending on domestic goods. I.e. more money (gold) flows abroad and boosts foreign income and reduces
effective demand for domestic output. On the other hand when there is balance of trade surplus(X>M) there

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is more money(gold) inflow which increases effective demand for domestic goods (output) then increase
output production then which bring economic growth for the nation.
This implies a country should keep balance of trade surplus to expand its economy.) The volume of money in
a given country determines the volume of transaction of goods and services produced at specific time period.
Thus, an increase in the stock of money growth (Ms) resulted from trade surplus; stimulate economic growth
through increasing the volume of transaction (T) according to mercantilist.
The Physiocrates
Physiocrates deal with feudal economy of French and illustrates the flow of commodities through the process
of production and consumption like the modern input –output analysis. In feudal economy there are three
social classes: land lords, peasant and Artisans. According to them
 It was wrong for the government to tax peasants since taxation depletes the stock that is necessary for
them to use in the course of reproducing the surplus.
 It was necessary to improve method of production to increase the productivity of land to expand the
total surplus.
The Classical school of thought (1776-1936)
The ruling principle was the invisible hand coined by Alfred Marshall.
Major Assumption
 All markets including labor market always clear (the economy always operates at equilibrium and at
equilibrium all resources are fully employed).
 No government intervention is needed in the form of stabilization policies; it is neither desirable nor
necessary to achieve full employment.
 All economic agents (firms and households) are rational and aim to maximize their profit or utility.
 All markets are perfectly competitive.
 All agents have perfect knowledge of market conditions
 Trade only takes places when market clearing prices exist in all markets.
 Agents have stable expectation.
Demand-side policies mainly affect nominal variables such as interest rate and prices while supply side
polices affect real variables such as real wage, employment and output.
Output determination
According to classical, the level of real output will be determined independent of the quantity of money in the
economy. This is known as classical neutrality proposition. Rather a country can expands the total amount
of output produced through increasing the amount of input under production and increases their productivity
through technological progress.
Employment determination
Aggregate level of employment determined through labor market equilibrium established from profit
maximization behaviors of firms and utility maximization behavior of households.
Say’s Law: classical however, there is no possibility of deficiency of aggregate demand by appealing to say‘s
law. This law would be stated as: supply creates its own demand.
According to the classical view, at full employment level of output an expansion of money supply results
inflationary pressure.
Keynesian School (1936 – 1970s)

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Major assumptions
 In general theory of Keynes interest rate is purely a monetary phenomenon determined by the
liquidity preference (demand for money) of the public.
 Keynesian rejects the classical notion of neutrality of money
 Rise in the general price (Inflation) is the result of increase in nominal wage. An increase in wage
causes an increase in aggregate demand. These will cause excess demand over the amount of output
supplied resulting inflationary condition.
Keynes and Economic Policy
For Keynes to do about recessions, the first and most obvious thing to do is to make it possible for people to
satisfy their demand for more cash without cutting their spending, preventing the downward spiral of
shrinking spending and shrinking income. The basic Keynesian answer to recessions is a monetary
expansion.
The economy is inherently unstable and subject to erratic shocks. The economy can take long time to return
to full employment level after being subjected to some disturbance, i.e. the economy is not rapidly self-
equilibrating because of the rigidities of prices. As a result involuntary unemployment of labor is the major
feature of Keynesian school. Therefore fiscal and monetary policies play an important role in stabilizing the
economy. Since prices and wages are not perfectly flexible and changes in aggregate demand both anticipate
or unanticipated, will have great effect in the short run on real output and employment rather than on nominal
variable.
The aggregate level of output and employment is essentially determined by aggregate demand. The
authorities can intervene to influence the level of aggregate effective demand to ensure a more rapid return to
full employment to improve the performance of the economy.
Monetarism
Monetarism, as advocates of free market, started challenging Keynes‘s theory in the 1970s. Milton
Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle on the ground that
such active policy is not only unnecessary but actually harmful, worsening the very economic instability and
should be replaced by simple, mechanical monetary rules.
According to monetarist view most recessions, including the Great Depression occurred because of a fall in
the quantity of money in circulation rather than the private sector was trying to increase its holdings of a
fixed amount of money.
Basic Issues
 Monetary policy is best tool to make the economy stable
 Money is not neutral:- if the workers expect the government to increase the money supply , they will
bargain to gain high wage rate contract ahead of time .
 Inflation is essential monetary phenomena.
 Against government intervention
Policy Rule under Monetarism
A straightforward rule- ―Keep the money supply steady‖- is good enough, so that there is no need for a
―discretionary‖ policy of the form, ―Pump money in when your economic advisers think a recession is
imminent.
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New classical
The central working assumptions of the new classical school are three:
 Economic agents maximize. Households and firms make optimal decisions given all available
information in reaching decisions and that those decisions are the best possible in the circumstances in
which they find themselves.
 Markets clear. There is no reason why firms or workers would not adjust wages or prices if that
would make them better off.
 Expectations are rational, which means they are statistically the best predictions of the future that
can be made using the available information.
New Keynesians
They believe that markets sometimes do not clear even when individuals are looking out for their own
interests. Both information problems and costs of changing prices lead to some price rigidities, which help
cause macroeconomic fluctuations in output and employment.

CHAPTER TWO
NATIONAL INCOME ACCOUNTING
2.1 Gross Domestic Product (GDP)
 Gross domestic product is often considered the best measure of how well the economy is performing
 GDP means the total market value of all final goods and services produced within a given period by
factors of production located within a country. It includes the total expenditure on domestically-
produced final goods and services and total income earned by domestically-located factors of
production.
Calculating GDP
Product/Value added approach: - value added represents the value of firms‘ output minus the value of
intermediate goods bought from another firms. In this approach GDP is calculated by adding the market
value of all final goods and services produced in each sector. We use value added approach to avoided double
counting
Expenditure approach: a method of computing GDP that measures the total amount spent on all final goods
and services during a given period.
The expenditure components of GDP are Consumption, investment, government spending, and net exports
GDP = C + I + G + (EX  IM)
Consumption(C):- It consists of the household sector purchase of currently produced goods and services.
Consumption can be further broken down in to consumer durable goods (e.g. automobiles, television…),
nondurable consumption goods (e.g., foods, beverages …) and consumer services (e.g. medical service,
haircuts…)
Investment (I): Spending on the factor of production, capital and spending on goods bought for future use. It
consists of Business fixed investment, Residential construction investment and Inventory investment
Government purchases (G): it is the share of the current output bought by the government. It is important to
note that not all government expenditures are part of GNP because not all government expenditures represent
a demand for currently produced goods and services. Government transfer payments and government interest
payments are examples of expenditures that are not included in GDP/GNP

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Net exports (NX): Net export equals total (gross) exports (X) minus imports (M). These items represent the
direct contribution of the foreign sector to GNP.
Income approach: Income approach is a method of computing GDP that measures the income wages, rents,
interest, and profits received by all factors of production in producing final goods and services. Measures
GNP in terms of income earned by the factors of production. In this approach sales of assets produced at
earlier period and income obtained from sales of bonds and stocks are also excluded in the computation of
GNP.
Components of GNP in the income approach:
Compensation of employees, Proprietors income: the income of non-corporate business (owner managed
business), Corporate profits (the income of corporations after payments to their workers and creditors),
Rental income (Income earned from renting land) , Net interest (it is interest earned by businesses (domestic
+ foreign ) minus interest paid by them), Indirect business tax (taxes such as sales tax, excise tax, custom
duets), etc, which is not part of the income of business organizations, and Capital consumption allowance or
depreciation

How can GDP measure both the economy‘s income and the expenditure on its output? The reason is that
these two quantities are really the same: for the economy as a whole, income That fact, in turn, follows from
an even more fundamental one: because every transaction has both a buyer and a seller, every dollar of
expenditure by a buyer must become a dollar of income to a seller.
Rules for Computing GDP
To compute the total value of different goods and services, the national income accounts use market prices.
 Used goods are not included in the calculation of GDP.
 The treatment of inventories depends on if the goods are stored or if they spoil. If they spoil, GDP
remains unchanged while if the goods are stored, their value is included in GDP.
 Intermediate goods are not counted in GDP
 Some goods are not sold in the marketplace and therefore don‘t have market prices. We must use
their imputed value as an estimate of their value, Renters purchase, No imputation is made for the
value of goods and services sold in the underground economy.
Is GDP is flow or Stock concept
A stock is a quantity measured at a given point in time,
A flow concept is a quantity measured per unit of time. To illustrate flow and stock concept, the amount of
water in bath tub and the quantity of water added to bath tub is used. The amount of water in the tub is a
stock whereas the quantity of water added and leak out from the tub per unit represents a flow.
GDP of a given economy measure in the same manner as the amount of water moving in to and out of the
bath tub. This implies GDP is a flow concept. It tells us the amount of dollars flowing among different
economic agent (firms, households and other) per year or months
GNP vs. GDP
 Gross National Product (GNP): Total income earned by the nation‘s factors of production,
regardless of where located.

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  Gross Domestic Product (GDP): Total income earned by domestically-located factors of production,
regardless of nationality.
(GNP – GDP) = (factor payments from abroad) – (factor payments to abroad) Where net factor Income is the
difference between factor payment from aboard and factor payment to abroad.
Other Social Account
 National Income (NI) – It is the total income earned by resource owner from current production.
National income can be computed in two ways. First, by summing up the factor incomes earned in
producing total output. Second, by making adjustment to net national income through subtracting
indirect business tax from NNP.
 NI= NNP-Indirect business tax (e.g. sales tax)
 Personal income (PI) =National Income-corporate profit - Social Insurance contributions - Net
interest + Dividends + Government transfer + Personal interest income
 Disposable personal income (DI)- Households non corporate business income that is really to spend
after tax and non-tax payments. Disposable income would be either consumed or saved.
 DI=consumption + saving
 Disposable income (DI) = personal income-Personal tax and non-tax payments
 Net domestic product (NDP):- It represents the value of total output of an economy after net out
depreciation. NDP= GDP – Depreciation
 Net National Product: - measures the value of total output produced by a citizen of a given country
within a specified time period after subtracting the consumption of fixed capital (depreciation).
NNP= GNP – Depreciation
Real vs. nominal GDP
GDP is the value of all final goods and services produced.
 Nominal GDP measures these values using current prices.
The problem with such type of valuation of good and services is that it could not reflect the cause for change
in GDP resulted from change in price or change in quantity of output overtime. There are cases where GDP
changes without any change in amount of output of an economy when there is change in prices.
 Real GDP measures these values using the prices of a base year.
It is computed after adjusting for change in price from year to year. Therefore, to compute real GDP first set a
base year price and then value all the output produce in different year at the selected base year price.
When price held constant, the real GDP varies from year to year only when the quantities produced vary.
Thus real GDP measure changes in physical output in the economy between different time periods by valuing
all goods produced in two periods at the same prices.
Real GDP controls for inflation
Changes in nominal GDP can be due to changes in prices and changes in quantities of output produced.

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Changes in real GDP can only be due to changes in quantities because real GDP is constructed using constant
base-year prices.
GDP Deflator & CPI
 To measure the general price of an economy GDP deflator, consumers and producer price index are
used.
GDP deflator
 GDP deflator also called the implicit price deflator for GDP is defined as the ratio of nominal GDP to
real GDP.
 GDP Deflator = Nominal GDP/Real GDP*100
 It measures the price of output (goods) relative to its price in the base year. It shows whether the price
of good increase or decreases in reference to the base year price.
 Real GDP= nominal GDP/GDP deflator
The GDP deflator is a weighted average of prices. The weight on each price reflects
that good‘s relative importance in GDP. Note that the weights change over time.
Consumer price index (CPI)
CPI is the most commonly used price index used to measure the general price of an economy. It represents
price of a fixed basket of goods and services purchased by a typical consumer relative to the same basket of
goods and services in some base year. CPI for the indicated goods shows that, how much the basket of goods
costs currently relative to what it cost in the base year.
Producer price index: measures the price of typical basket of goods bought by firms.
Reasons why the CPI may overstate inflation
 Substitution bias, introduction of new goods, unmeasured changes in quality:
CPI vs. GDP Deflator
Prices of capital goods included in GDP deflator (if produced domestically) but excluded from CPI. Prices of
imported consumer goods included in CPI but excluded from GDP deflator. The basket of goods in CPI are
fixed but in GDP deflator they change every year

Limitation of GDP Concept

GDP and Social Welfare
 If crime levels went down, society would be better off, but a decrease in crime is not an increase in
output and is not reflected in GDP.
 An increase in leisure is also an increase in social welfare, sometimes associated with a decrease in
GDP.
 Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP
even though they amount to real production.

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  GDP also has nothing to say about the distribution of output among individuals in a society.
 Underground economy the part of the economy in which transactions take place and in which
income is generated that is unreported and therefore not counted in GDP.
The Business Cycle
The ups and downs of the economy, in the short run are known as business cycle. It is a regular pattern of
expansion and contraction in economic activity around trend growth. The deviation of output from the trend
level (Output gap, actual GDP – potential GDP) shows the change in level of employment of resources from
full employment level.
 Positive output gap shows over employment of resources and utilization of improved method of
production (actual output>potential output)
 Negative output gap shows under employment of resources and utilization of improved method of
production (actual output< potential output)
Unemployment & Inflation
Unemployment: is a situation in which able bodied persons (16 -65 years) willing to work at prevailing wage
rate but do not able to find job.
 It is measured by rate of unemployment not in the labour force
 Labour force: the number of people employed plus the number of unemployed.
Unemployment rate: measures the ratio of the number of people unemployed to the total number of people
in the labour force.
Labour force participation rate: measured as the ratio of the labour force to the total population 16 years
old or older.

Types of Unemployment
Frictional unemployment, Structural unemployment and Cyclical unemployment
Economic Cost of Unemployment
 Employed workers produce goods and services whereas unemployed workers do not thus an increase in
the unemployment rate decreases the real GDP of an economy. This negative relationship between
unemployment and GDP is known as Okun’s law states unemployment rate declines when growth is
above the trend rate.
 The other cost of unemployment is that it reduces living standard. Unemployment has also income
distribution effect. It causes inequality among employed and unemployed workers
Noneconomic Costs
• Loss of skills and loss of self-respect, Causes psychological distress, Plummeting morale, Family
disintegration, Poverty and reduced hope, Heightened racial and ethnic tensions, Suicide, homicide, fatal
heart attacks, mental illness, Can lead to violent social and political change
Inflation

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In a broad sense, inflation is defined as a sustained rise in the general level of prices. Two points about this
definition need emphasis.
 First, the increase price must be a sustained one, and it is not simply a once for all increase in prices.
Second, it must be the general level of prices, which is rising. Increase in individual prices, which can be
offset by falling in prices of other goods is not considered as an inflation
Causes of Inflation
 Demand-Pull inflation (Demand pulls factors Inflation is resulted from more rapid increase in demand
for goods and services than supply
 Classical explanation: The increase in demand is the result of monetary expansion,
 Keynesian explanation: Aggregate demand increases due to an increase in real factors such as
increase in consumer demand, investment demand, government expenditure & net export
 Cost push inflation (supply side factors) occurs when different factors which increase cost of
production and other structural bottleneck cause firms to reduce the supply of goods and services below
existing demand.
Causes of Inflation in developing countries
 The standard theories of inflation built up on developed economies have little relevance to developing
economies.
 Therefore anti-inflationary policies based on the standard theories have very little impact to reduce
inflation in developing economies.
A better theory to explain inflation in developing countries is the Structuralism view; inflation in developing
economies is caused mainly by the structural imbalances in these economies
 Less developed economies are characterized by highly fragmented market, market imperfection,
immobility of factors input, wage rigidities, high unemployment and Sectoral imbalances with surplus in
some sector and scarcity in the other sectors.
 As a result developing economies are characterized by high rate of inflation with large scale of
unemployment.
Effect of inflation
Inflation hurt Fixed-income receivers, Savers and Creditors but not affects Flexible-income receivers Social
Security recipients and Union members Debtors Pay back the loan with ―cheaper dollars‖
Economic Effect of Inflation reduces real money balance or purchasing power of money, so it reduces the
welfare of individuals.
Measures to control inflation are monetary measures, Fiscal measures, Price and Wage and control measures

CHAPTER THREE
3. AGGREGATE DEMAND ANALYSIS OF CLOSED ECONOMY
3.1. Definition of Aggregate Demand (AD)
Aggregate demand shows the level of real GDP purchased by households (C), business firms (I), government
(G) and foreigners (NX) at different level of prices. It therefore expressed in terms of its components as:

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 AD=C+I+G+NX
Alternatively aggregate demand can be defined as the relationship between the quantity of output demanded
and the aggregate level of prices. Other things remain constant if price decreases aggregate demand increases
and vice versa. This aggregate demand can be represent by down ward sloping curve in general price vs.
quantity of output demanded.
Why do aggregate demand curve is downward sloping? We can explain the downward sloping of the
aggregate demand curve by thinking about the supply and demand for real balances. If output is higher,
m
people engage in more transactions and need higher real money balance ( p ). For a fixed money supply M,
higher real balances imply lower prices level. Conversely, if price level is lower, real money balances are
higher; higher level of real balances allows a greater volume of transactions, which means greater quantity of
output demanded.
But aggregate demand with its components has positive relation (AD demand becomes upward sloping).
3.2. Aggregate Demand Analysis in Goods Market
3.2.1 Keynesian Cross Model
Keynesian cross model is the base for ISLM model. It is built from the concept of planned and actual
expenditure. Actual expenditure is the amount households, firms and government spend on goods and
services. It is equal to GDP of an economy (Y). Planned expenditure is the amount households, firms and
government would like to spend on goods and services. Planned expenditure is the same as aggregate demand
of closed economy:

In simple Keynesian cross model we assume planned investment is exogenous (I= I ) and tax is also assumed
to be fixed (T= T ). Thus E= C(Y- T ) + I + G .

In KC model, the economy reach equilibrium when actual expenditure (quantity of output produced) equals
planned expenditure (aggregate demand) or (Y=AD). Any deviation from this equilibrium level causes
change in unplanned inventory investment or disinvestment (IU). It is represents the difference between Y
and AD (IU=Y-AD). This value acts as signal for firms to induce production or decreases production of
goods and services accordingly.
When IU = Y – AD =0, the economy is quilibrium. If
actual expenditure is greater than planned expenditure, firms are selling less than their production. Under
such condition firms add the unsold goods to their stock of inventories resulting in increase in inventory
investment. This increase in inventories act as signal for firms to cut production of output until planned
expenditure is equal to actual expenditure. Similarly, if the output is less than equilibrium level, planned
expenditure is greater than actual expenditure. This means the output produced is below aggregate demand.
Therefore to meet the high demand in the economy firms run down their stock of inventory (unplanned
inventories disinvestment) takes place. The running down of inventory investment gives signal for firms to
put more resources under production to increase output production up to point of equilibrium. Hence
through adjustment of inventories, the equilibrium level of Keynesian cross model is maintained when the
economy is not in equilibrium. (See detail explanation and examples for KC model from N. Gregory
Mankiw macroeconomics books or from other macroeconomics modules)
3.3.2.2 Keynesian Cross Model and the Multipliers

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To simplify the analysis it is assumed that investment, government purchase and taxes are determined outside
of the model (autonomous). AD= A + bY where, A =a-b T + G + I
At equilibrium planned expenditure (AD) is exactly equal to actual expenditure. Y= A + bY
1
Rearranging the above equation, equilibrium level of output, Y= A
1 b
Thus equilibrium level of output changes when autonomous spending and marginal propensity to consume
1
(b) changes. y  A
1 b
y 1
 Any change in the autonomous spending or the component of autonomous
A 1b
1
spending changes the equilibrium level of output by a factor of (the multiplier) (refer any
1 b
macroeconomics books for the detail determination of output (income) and derivation of multipliers)
In summary the concept of autonomous spending multiplier suggest that output changes when autonomous
spending changes and the change in output can be larger than the change in autonomous spending.
3.3.3. Fiscal Policy and the Multiplier
Government directly affects the level of equilibrium income in two separate ways. First, through changing in
government expenditure on goods and services. Secondly through taxes and transfer payments which affect
disposable income. Government follows different policies with regard to government expenditure and tax
structure to achieve a certain target of output levels. Such policies are known as fiscal policy.
Suppose government increase its expenditure and decreases taxes imposed on households. An increase in
government purchase raises aggregate demand for a given level of income. The rises in aggregate demand
induces firms to produces more so that there is rise in equilibrium level of income and causes rises in
consumption, which in turn causes a further rises in income through expansion of aggregate demand. Such
interaction continues resulting in a greater increase in income that increases in government spending, i.e.
Y
 1.
G

G AD Y C AD Y…….

y 1
= is called government purchase multiplier. It measures the amount of change in income as a
G 1  b
result of a unit change in government expenditure. This value is positive and shows the positive impact of
government purchase on equilibrium level of income.
Alternative to government expenditure taxes affect aggregate demand through its effect on consumption of
goods by household. For instance, a change in tax by  T causes change in consumption by b  T. For a
given level of income, this change in consumption spending by b  T will change aggregate demand by the
same amount. A change in aggregate demand by its turn causes a change in income, such process continues
b
like the case of government spending, in which change in taxes cause change in income by a factor of ,
1 b

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y b  b
  .the expression is said to be tax multiplier. It is the amount of income changes for a unit
T 1b 1 b
change in tax revenue. This value is less than zero to indicate tax has negative impact in the expansion of
aggregate demand and equilibrium level of income.
Note that the government multiplier decreases when tax revenue is a function of income. This is because
as tax revenue rises with income, the increase in disposable income decreases at each round when
expenditure expands compared to the case where taxes are assumed autonomous. (Refer different
macroeconomics books and modules for the detail derivation of multipliers and numerical examples)
Numerical illustration
Given an economy described by the following functions
C 10 0 0.
85Yd
,I  20 0,G  295
w
h
er
e
Yd

YT
Find
a) The equilibrium level output and consumption if tax revenue is equal to 100.
b) Determine the value government purchase and tax multiplier and interpreter your
result.
c) Calculate the change in equilibrium output if government purchase (G) increase by 100 units.
3.3. 4.The IS Curve
Unlike that of Keynesian cross model, in reality investment depends on interest rate for two main reasons. In
order to invest, firms must either borrow or use its own funds. In either case, the cost of borrowing can be
measured by interest rate. The firm has to pay interest or there is interest income foregone in case own fund is
used to finance investment projects. Consequently, higher interest rate may result in lower profit by
increasing cost, and then firms‘ willingness to borrow and to invest decreases and vice versa. Thus, we can
easily conclude that there is inverse relationship between investment and interest rate.
dI
I  I (r ) , = I‘<0
dr
I‘- the slope of investment function representing the responsiveness of investment to interest rate. If I‘ is
large, then relatively small increase in interest rate general result in a greater drop in investment spending.
The next task is deriving IS curve using the relationship between investment and interest rate with Keynesian
cross model.
By incorporating interest rate on investment function the aggregate demand equation is given by.
A D  C Y
() ()
Ir G

IS curve is negatively sloped, reflecting the inverse relationship between interest rate, and aggregate demand
(income). That is a higher level of interest rate reduces investment spending, thereby reducing aggregate
demand and thus the equilibrium level of income. Its slope depends how sensitive investment to interest rate.
If investment is very sensitive to interest rate, a small change in interest rate cause a large shift in aggregate
demand and cause large change in equilibrium income resulting in flat IS curve. If investment is less
sensitive to interest rate IS becomes relatively steeper. (Refer macroeconomics books and modules for the
detail derivation of IS curve)

3.3.6. Fiscal Policy and IS Curve

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One way of identifying whether fiscal policy cause outward or inward shift in IS curve is through
understanding the impact of the policies on demand using Keynesian cross model. Suppose there is decrease
in tax or increase in government expenditure. Both changes result in increase in aggregate demand causing
upward shift in aggregate demand curve, which results in higher level of equilibrium output for fixed level of
interest rate. Therefore, increase in government purchase or decrease in tax results in outwards shift in IS
curve to show increase in income. On the other hand a decrease in government expenditure or increase in tax
reduces income by reducing aggregate demand will cause IS curve to shift inward.
Alternatively, the impact of fiscal policy on IS curve can be explained by considering its impact on national
saving. For instance, an increase in government purchase or decrease in taxes reduces national saving for any
given level of income. The reduced supply of loan able funds raises the interest rate that equilibrates the
money market. Because the interest rate become higher for any given level of income, the IS curve shift
inward in response to contraction fiscal policy (decrease in government expenditure and increase in tax).

3.4. Money Market and LM Curve

LM curve represent combination of interest rate, and income associated with equilibrium in the money
market. Equilibrium in the money market occurs where the demand and supply of money are equal through
the adjustment made through interest rate. How can we establish the relationship between equilibrium
income and interest rate in the money market? We can use the theory of liquidity preference and /or the
quantity theory of money to determine the relationship between interest rate and income in the money
market.
M M
LM: = L(r, y) represents real money supply and L(r, y) real money demand
p where p
Theory of liquidity preference
The theory of liquidity preference explains how the supply and demand for real money balance interact to
determine interest rate prevailing in the economy. To understand how the interactions between money
demand and supply determine interest rate, it is helpful to understand first factors affecting demand and
supply for real money balance.
Demand for money
Demand for money refers to the willingness of economic agent to hold the liquid asset (cash). Why people
demand money? There are different motives that why peoples hold their asset in the form of cash. First,
people hold cash to smooth their daily transactions (receipts and payments). The daily transaction of people
however depends on their real income. As income increases the transaction, in which peoples involve
increases. Therefore, they hold more cash to smoothen the transactions. This implies the demand for money,
which is known as transaction demand for money has positive association with real income of individuals.
Secondly people hold cash as an alternative form of asset by comparing with the return obtain from the other
alternative forms. That is the demand for money depends on cost of holding money. The cost of holding
money is the interest rate that is forgone by holding cash rather than keeping in the form of interest bearing
asset such as bonds and bank deposits. When interest rate rises, people must hold less of their wealth in the
form of cash to reduce cost of holding money. This inclination to hold more or less cash depending on
interest rate on bonds and bank deposit is known as speculative demand for money. In summary the demand
for real balance depends on the level of real income and the interest rate.
According to theory of liquidity preference, money market equilibrium attained through adjustment of
portfolio of asset holding. For instance, if there is excess money supply than demanded, interest rate of the
economy becomes higher than the equilibrium level. Hence, to adjust downward to equilibrium level,

14 | P a g e
individuals are converting excess money to interest bearing bonds and bank deposit. On the other hand when
the supply of real balance is less than real money demand, the reverse adjustment would happen to restore to
equilibrium level.
LM curve would be steeper or flatter depending up on the responsiveness of demand for money to income
and responsiveness of demand for money to interest rate. That is if demand for money is highly responsive to
money and less responsive to interest rate LM curve is steeper and vice versa. (Refer different
macroeconomics books for the derivation of LM curve)
3.4.2. Monetary Policy and LM Curve
LM curve is derived using both the theory of liquidity preference and quantity equation of money. That is
money supply determined outside the model by central bank of a country. This implies money supply is a
variable that is used by government as monetary policy instrument to intervene in financial market. That is
the excess supply of money pushes the equilibrium interest rate down, increase in money supply causes
outward shift in LM curve to the right.
On the other hand, decrease in money supply for fixed level of income and price, causes a reduction in real
money balance which in turn creates excess demand in money market. This will cause interest rate to rise
and clear the market. Hence decrease in money supply causes LM curves to shift in ward to the left.
3.5. Short Run Equilibrium of Goods and Money Market: ISLM Model
Solving the equation of IS and LM simultaneously we can get a single pair of interest rate and income that
satisfy equilibrium of both money and goods market. When the economy is in disequilibrium, it moves
toward equilibrium through the interaction of both markets.
Once ISLM model is constructed, we use it next to see how change in exogenous policy variables such as tax
, government spending and money supply influence equilibrium level of output and interest rate in the short
run (with fixed price level). Later on we will see the derivation of Aggregate demand from ISLM model.
3.5.1 Monetary and Fiscal Policies in ISLM Model.
Monetary and fiscal policies are generally termed as demand management policy. This is because they are
used to manage the aggregate demand accordingly to achieve high economic growth coupled with stable
level of price. For instance, when there is excess demand in the economy than supply, it will pull up prices
resulting in inflationary condition. In such cases fiscal and monetary policies targeted to reduces the excess
demand to stabilize the price level. That is, decreasing government expenditure, decrease in money supply
and increase in tax which are known as contractionary polices are used to reduce excess demand in the
economy.
In this section we will discusses thoroughly how monetary and fiscal policies cause change in equilibrium
level of income and interest rate through considering the impact it has in goods and money market.
3.5.1.1. Fiscal Police and ISLM Model
Let us consider first an increase in government purchase with tax schedule remain constant. The increase in
government purchase expands planned expenditure. The expansion of aggregate demand stimulates the
production of goods and services through a multiplier process. If the interest rate remain constant (investment
assumed to be exogenous) as in the case of KC model, IS curve shifts outward and result in new equilibrium
level of income higher than the original. But the increase in income resulted from change in government

15 | P a g e
 M 
expenditure increases transaction demand for money. With fixed supply of real money balance  P , the
 
increase in demand for money causes increase in interest rate
In addition, the increase in government expenditure when taxes remain constant would causes government
budgetary deficit. To finance this deficit, government should increase the amount of bond sold. To sell more
bonds, the government must raise the interest rate (increases bond prices) as an incentive. In both cases
increase in government expenditure increases interest rate.
Beside its impact on interest rate through money demand and bond price, government expenditure increases
interest rate by reducing total saving of the economy. When the saving of the economy squeezed down for a
given level of investment demand, the total demand for loan able fund is greater than its supply. This will
induces interest rate to increase.
Since investment is a function of interest rate, the increase in government expenditure results in fall in
investment through rising interest rate. That is expansion of government expenditure causes partial
displacement of private investment. This is known as crowd out effect of government expenditure expansion.
The fall in investment decreases output and income. This will offset partly the expansionary effect of rise in
government expenditure on output. Thus, the increase in income in response to expansionary fiscal policy is
smaller in ISLM model compared to Keynesian cross model. In summary we can represent crowed out effect
of investment.
md
 Y  r
p
G S r  I (r) AD
 Bond price

Other expansionary fiscal policy: decrease in tax

In ISLM model, a change in taxes affects the economy the same as change in government purchase. But, tax
affect aggregate demand through its impact on consumption spending. For instance, decrease in tax
encourages more consumption spending through increasing disposable income and then increase in aggregate
demand of the economy. Increase in aggregate demand increase income in case of Keynesian cross if
investment is assumed to be constant. But when investment is a function of interest rate, the increase in
income due to cut in tax creates excess demand in the money market which cause raise in interest rate along
 dI 
IS curve   0 . Thus, like the case of government purchase, tax cut in ISLM frame work partially offset
 dr 
the expansionary effect of increase in consumer spending by reducing disposable income of consumers.
3.5.1.2. Monetary policy and ISLM model
As we have seen with liquidity theory of money, increase in money supply for a given level of price and
income, decreases interest rate.
When money supply increases people hold more money than they wants to hold at prevailing interest rate. As
a result they start to deposit extra in banks or use it to buy bonds. This would push down interest rate. Thus
increase in money supply causes LM curve to shift downward to the right. The decline in interest rate
increases investment demand and raises the level of output and income moving the economy to higher level
of income and lower level of interest rate. Hence, unlike fiscal policy which affects income through its
impact on consumption spending, monetary policy changes equilibrium output through its impact on interest
rate and then investment.

16 | P a g e
3.5.2. The interaction of monetary and fiscal policies
In reality fiscal and monetary policies are used at the same time in combination to achieve a desired position
to the economy‘s demand and then output. A change in one policy therefore may influence the other policy to
be used. For example if government wants to reduce budgetary deficit, it would increases the taxes imposed.
What is the impact of such policy on the economy and how monetary authorities respond to this policy
change?
Increase in tax reduces consumption spending and therefore aggregate demand by reducing disposable
income. This will cause inward shift in IS curve and reduces income and interest rate assuming that money
supply remain constant.
In response to the impact of tax increase or in combination to tax increase, monetary authority implement
monetary policy depending up on the objective intended to be achieved. Suppose the target of the
government is to finance budgetary deficit without affecting the interest rate. To retain the interest rate at its
original level, monetary authorities should decrease money supply. The decreases in money supply increases
interest rate and reduce investment, which causes further decrease in equilibrium level of income. This will
result in upward shift in LM curve to maintain constant level of interest rate.
Now suppose that the target of government is to maintain income constant with increase in tax. How
monetary authorities react to achieve the target? Monetary authorities increases money supply which causes
outward shift in LM curve, this will offset the contractionary impact of increase in tax and keep income
constant at original position. Here higher tax depresses consumption and reduced income while monetary
expansion increase output by reducing interest rate.
Illustrative example:

Given the goods and money market structures of a given closed economy as follows:
C= 200 + 0.75 (Y-T) , T = 200
I= 200 – 0.25 r
G= 100
d
m
 y 100 rm s 10 0
0P  1
p
a) Find the IS and LM equation
b) Equilibrium interest rate and income
dy
drdr dy
c) Find dG , , and , interpret the values.
dG dmdm
3.6. Aggregate Demand and ISLM Model
In the previous section we have seen that how the intersection of the IS and LM curves determines the
equilibrium level of income and interest rate by assuming the price level is fixed. Now let us relax this
assumption to drive the economy‘s aggregate demand curve. What happen to the equilibrium level of income
when price change?
When price level increases for whatever reasons, the real money supply shrinks and excess demand in the
money market created. This excess demand raises interest rate, reducing investment demand and then
income. On the other hand, if there is reduction in price level, real money supply increases resulting in
decrease in interest rate and increases in investment demand. The increase in investment demand because of
decrease in interest rate expands the output and income level of the economy. Thus, varying the price level
produces opposite variations in the equilibrium level of output demanded in the economy; as price raises, Y
falls and vice versa. This relationship gives the economy‘s demand curve.

17 | P a g e
What causes aggregate demand curve to shift? Since aggregate demand curve is a summary of the
equilibrium condition of the ISLM model, events such as change in exogenous variable that shifts the IS or
LM curve for a given price causes the aggregate demand curve to shift. That is expansionary fiscal and
monetary policies shifts demand curve outward whereas contractionary fiscal and monetary policy cause shift
aggregate demand curve inward.
3.7. ISLM Model in the Long Run
So far we use ISLM model to explain the economy in the short run when price level assumed to be fixed.
Now let us consider when the prices are assumed to be flexible in the long run. When prices are flexible in
the long run as classical assume, the price level adjusts to ensure national income is always operate at full
employment level. That is aggregate supply curve is vertical. Thus, to solve the model in the long run the

assumption that output level is equal to the natural rate (Y= Y ) is included to complete the model

IS: Y=C ( Y -T) + I (r) + G

m 
LM: = L(r, y )
p
Given with the flexibility assumption of prices, is monetary and fiscal policy effective in affecting the real
variables in the long run? Let us begin by considering monetary policy by representing the economy with

the following ISLM model with the assumption of Y= Y ( vertical aggregate supply curve).

Suppose that there is increase in money supply by the central bank of a given country. This will result in
outward shift in LM curve to the right causing lower interest rate than the original equilibrium level. The
decrease in interest rate induces more investment and then expands aggregate demand. The increase in
aggregate demand in turn results in increase in price. When price increase proportionately to monetary
expansion, real money balance decline causing back ward shift in LM curve to its original position.
Monetary policy expands output in the short run when the economy is under full employment. In the long
run however, monetary policy only affects nominal variables such as prices without having any effect on real
variables. From this we can conclude that monetary policy is ineffective to affect real variables such as output
and employment in the long run, instead it has inflationary impact on the economy.
Next let us consider the impact of fiscal policy on the equilibrium level of output in the long run. If
government expenditure increases, it expands aggregate demand. This will by its turn cause increase in prices
which can be represented by outward shift in aggregate demand curve. Also the increase in aggregate demand
due to increase in government expenditure shifts IS curve outward. On the other hand, increase in price due
m
to expansion of aggregate demand causes reduction of real money balance ( p ), which causes inward shift
in LM curve to the left resulting in higher level of interest rate. Hence, fiscal policies are not effective in the
long run to affect real variables. Like the case of monetary policy fiscal policy has impact on nominal
variables only.

CHAPTER FOUR
4. AGGREGATE DEMAND ANALYSIS IN OPEN ECONOMY

4.1 External Sector and Aggregate Demand

18 | P a g e
In case of closed economy of Keynesian setup the expenditure on economy‘s output of goods and services (domestic
spending) determines domestic output. That is, country‘s output equal to the total amount of goods and services produced
in the economy(Y=AD). But in case of open economy domestic spending is not equals to domestic output. Domestic
spending could not totally determine domestic output and also domestic spending did not totally absorbed by the output
produced domestically. This is because partly domestic output is sold to foreigners (export) and part of the spending of
domestic residents made on foreign goods and services (import).

Therefore the national income identity can be given us

A
D
CI
GXM

From the expression of aggregate demand above, export spending (X) is an addition to the demand for goods
and services produced domestically. As a result export is known as an injection to domestic economy.
Thus, export expands the total AD for domestic output and initiate expansion of output. On the other hand,
import represents the expenditure on foreign goods and it reduces the demand for domestic goods and
services by expanding demand for foreign products and also reduces equilibrium output. Hence, import is
said to be a leakage from an economy‘s aggregate demand. A positive net export (X>M) shift AD upward
and increases equilibrium income while a negative NX (X<M) shift the AD curve downward and reduces
equilibrium level of income
We can also establish the relationship between domestic output, domestic spending and net export using national
income accounting identity as follows.

YCI X
GN
X Y 
N (CIG)
n
et d
omestic
e
xpor
t o
utp
ut dome
s tic
s
pendin g

The above rearrangement of national income accounting identity implies that domestic output may not be equal to
domestic spending. If AD>Y, the excess demand over domestic output meet through import ( NX is negative). In case
where the domestic output is greater than domestic demand ( NX is positive), the excess output exported to the other
countries.

4.2. Equilibrium income determination in open economy

In closed economy equilibrium national income is determined by domestic spending (aggregate demand) of the
economy. But for open economy, the equilibrium level of national income is determined when internal balance is
equals to external balance. Having the national income identity as follows and assuming both import and
consumption are functions of income YC  I GXM 
dC
CCa bY b,0b1
dY
dM
MMamY m0
dY
Where Ca and Ma are autonomous consumption and autonomous import respectively, m is the marginal propensity to
import. It measures the proportion of additional national income spent on import.

As in the case of KC model I and G are assumed to be exogenous. Also export is assumed to be exogenous. Now let us
incorporate the above stated assumption in to the national income accounting to identify the relationship between
income and internal balance; income and external balance

19 | P a g e
 YCIGXM
YC
abYIGX(MamY)
Y(C
abYIG)X(MamY)
YA
D (Y)N
X (Y)
in
terna
l externa
l
bala
nce balance

a
Where, AD is domestic aggregate demand which is equal to C bYIGand NX is net export or external
balance.

The concept of internal and external balance also helps us to illustrate inflow and outflow of capital to finance capital
accumulation (investment) in addition to flow of goods and services. For this purpose, once again consider the open
economy national income accounting identity.
Y 
CI X
GN
Y(
CG)
I N
X
Add and subtract tax (T) to the left hand side of the above equation and rearrange as follow:
(
Y
C) 
TTGIN
X
p
ubl
ic
p
ri
vat
e
s
av
in
g
s
av
ing

Saving of the economy(S)

S I NX
This implies: SI NX
SI  X M
S-I indicates international flow of capital while X-M represents the flow of goods and services. According to the
equation (S-I) = (X-M), if saving exceeds investment, the excess is used to make loan abroad or owner of the fund
invest in some other country ,that is there is outflow of capital . If saving is less than investment, there is excess
demand for fund that it is available in the domestic economy in the form of saving. This excess can be financed through
borrowing from other external source, which results in inflow of capital.
4.3. Open Economy Multipliers
4.3.1. Government Expenditure Multiplier
Like in the case of closed economy, government affects the national income by changing its expenditure and its
taxation. Since import depend on income, the government can also use fiscal policy (G and T) to affect trade balance.

dy 1
 .....Government expenditure multiplier for open economy
dG sm
Since marginal propensity to save and import is positive the government expenditure multiplier is also positive. This
implies an increase in government expenditure has expansionary effect on equilibrium level of income. If we compare
it with closed economy government expenditure multiplier, open economy multiplier is less than closed economy
multiplier since there is additional positive term (m) in the denominator.

dY 1 1
  (Closed economy)
dG 1b s
dY 1 1
  (Open economy)
dG1  
bms  m
20 | P a g e
 1 1
 In open economy, part of any increase in income goes to purchase of an import; that is foreign goods
s s m
rather than domestic good and generate foreign income rather than domestic income..
4.3.2 Export Multiplier
The impact of export on equilibrium level of income is described as follows
1
dY dCa d Id G d xdM a , assuming other autonomous variables, I, Ca , G and Ma are constant:
s
m
dY 1 dY
 …….Export multiplier,  0.
dX sm dX
As it is indicated above, export multiplier is positive and the same as that of government expenditure multiplier. But in
practice government expenditure multiplier effect is greater than the multiplier effect of export. This is because m for
government is smaller than m for export multiplier since government spending biased toward domestic goods and
services compared to foreign consumers. Therefore we can concluded that increase in government expenditure have
more expansionary impact on domestic income/ output than increase in export.
4.3.3. Import Multiplier
To illustrate the negative impact of import on domestic output, import multiplier for its autonomous part, part which
does not depend on income.
1 dy 1
d
Yd
Cd
X
d
Id
G
d
M, d  0
s
m
a a
M a sm

This implies autonomous import has a negative impact on equilibrium income.

4.3.4. Current Account Multipliers
Current account records trade in goods and services as well as transfer payments. Usually it is represented by the
difference between export and import. CAXM
Assume other variables are constant to see the impact of government expenditure on current account balance.
1
dCAm dG
sm
dCA m
 0
dG sm
This implies that increase in government expenditure deteriorates current account balance (make CA more deficit).
This is because increase in G expands the total output/income by increasing aggregate demand for goods and services.
When income increases, import demand increases for a given level of export and increase in import cause deficit in
current account balance. This is what the negative value of the multiplier indicates.

Effect of export on current account

Export positively affects current account balance:


dC
a m s
   
1 0
d
X sm sm

This implies an increase in export improves current account balance. But the improvement in current account is less
 s 
than increase in export  1 because partly the revenue obtained from export used to import different goods
 sm 
and services. As a result export through its impact on income by promoting import have partly negative effect on
current account balance that is why export multiplier is less than one. (Refer macroeconomics books for the detail
derivation of different multipliers)
4.4 Exchange Rate Determination
21 | P a g e
 Exchange rate is simply the price of one currency in terms of other currency. That means we can
express the price of one unit of foreign currency in terms of domestic currency or the price of one unit of
domestic currency in terms of foreign currency. There are two extreme methods of determining the price of
foreign currency (exchange rate).
a. Floating or flexible exchange rate regime
According to this regime exchange rate (the price of a currency) determined like others goods and services
price based on demand and supply conditions.
Demand for foreign currency is a derived demand. It is not demanded for its intrinsic value, rather it is
demanded for what it is used for. For example, demand for pound is derived from demand for UK goods.
Since demand for import is inversely related with its price, it is represented by downward sloping curve.
On other hand supply of foreign currency determined by the amount of export made to other countries,
unilateral transfers from abroad, inflow of capital through foreign directed investment, foreign borrowing,
aids and foreign deposit. Supply of foreign currency curve is upward sloping (has a positive relation with
exchange rate).
An increase in the price of foreign currency in terms of domestic currency is termed as depreciation. While a
decline in the price of foreign currency in the value of domestic currency is termed as appreciation.
Floating exchange rate can be clean or dirty. In case of clean floating exchange rate, exchange rate is
completely determined by demand and supply forces. If a country follow clean floating exchange rate the
official reserve of the country is equals to zero. While under managed floating exchange rate, central banks
intervene to buy and sell foreign currency in attempts to influence the exchange rate.
b. Fixed exchange rate regime
In fixed exchange rate system, exchange rate is assumed to be determined by the central bank of a country at
the point where the demand and supply of foreign currency overlap. For this purpose monetary authorities
has to hold an inventory of foreign currency that can be supplied in exchange for domestic currency.
Since less developed countries (LDCs) are characterized by shortage of foreign currency due to poor
performance of their export if there is increase in demand for foreign currency by the public, they cannot
supply the needed amount of foreign currency to keep fixed exchange rate. This will result in emerging of
parallel or black market.
Under fixed exchange rate regime government official increases or decreases foreign exchange to achieve
different economic objectives. Increase in prices of foreign currency in terms of domestic currency by official
action of government is known as devaluation while a decrease in exchange rate is termed as revaluation.
4.4.1 The Problem of Internal and External Balance
The fundamental problems for most open developing economies are current account deficits (external imbalance) and
high unemployment/inflation (Internal imbalance). However, these economies face a dilemma. The general solution to
the unemployment problem requires the economy to grow rapidly. This can be achieved by using expansionary
macroeconomic policies needed for economic growth. However, expansionary demand management policies cause an
increase in imports, widening the external imbalance directly and cause domestic inflation. Inflation also affects the
countries international competitiveness resulting in decrease in export and hence worsens the external balance further.
Thus, attempts to increase employment worsen the external balance further.
The conflict between internal and external balance arises from the Tinbergen instruments –target rule, which is stated
as: There must be at least as many effective instrument as targets to be achieved. This is because a policy instrument
can be favourable impacts on one target but unfavourable impact on the other. Furthermore, not all instruments can be

22 | P a g e
equally effective for every target. Thus, to achieve both internal and external balance simultaneously; domestic output
expansion and maintaining current account surplus, two independent policy instruments are needed. That is, it is
necessary to combine expenditure switching policies, which shift demand from imported goods to domestic output with
expenditure reducing (or expenditure increasing) policies in order to achieve the two targets of internal and external
balance. As we have pointed out before expenditure, switching policy that is used in combination to income expansion
policies is devaluation.

4.4.2 Analysis of Devaluation

In a fixed exchange rate system since government controls exchange rate, it is used as policy instrument to achieve a
given objectives. For instance, to improve current account balance government officially increase exchange rate. The
direct effect of devaluation is pioneered by Marshall (1923) and Lerner (1944) and later extended by Joan Robinson
(1937) and Machlup (1955 under the following assumption.

 The supply elasticity for the domestic export and foreign imported goods are perfectly elastic.
 Devaluation raises the domestic price of imports relative to exports. This cause decline in the term of
trade. Term of trade is simply the price of export divided by the price of import. The deterioration in
term of trade results in loss of real income because more export has to give up obtaining a unit of
imports. The term of trade effect however, has small effect from empirical studies of different
countries.
Now consider how devaluation used to solve the problem of internal and external balance. Devaluation as policy
instrument increases the price of foreign goods relative to those domestic goods. The rise in the price of foreign output
switch domestic demand away from imports towards domestic output there by stimulate import substitution production.
Moreover, devaluation causes decline in the price of the country‘s goods in terms of foreign currencies which improves
its international competitiveness (export becomes cheaper in terms of foreign currency) and thus increases export. This
means devaluation encourages export and discourages import and results in an improvement in country‘s trade balance
and solve the problem of external imbalance.

Is devaluation effective policy in achieving external balance (improving current account) always? According to the
proponent of direct effect approach of devaluation, it is effective if and only if Marshall-Lerner condition holds.

C
AXM
C
AP
XP
*
eM
Where P is domestic price level, X is the volume of domestic exports, P* foreign price level e is the exchange rate and
M is the volume of import. By assumption, domestic price and foreign prices are constant and normalized to unity.

 dCA 
 0 , then devaluation of domestic currency that is rise in e, will improve the current account balance. It is
 de 
positive if the sum of price elasticity‘s of demand for exports and demand for imports are greater than one (
x m 1). This is known as the Marshall –Lerner condition. If this condition holds then devaluation is likely to
improve the current account balance starting from equilibrium (CA=0). If the sum of the two elasticities is less than
unity then devaluation will lead to a deterioration of current account.

Devaluation work better for industrialized countries than for developing countries. This is because Marshall - Lerner
condition relatively holds for industrialized countries than for developing countries. For instance, a study for 15
industrialized countries shows on average the value of x m 2over two third year time horizon. This is resulted
from the fact that industrialized countries have competitive export and therefore the price elasticity of demand for
export may be quiet elastic.

23 | P a g e
However, for most developing countries Marshall-Lerner condition could not hold since their import and export
demand elasticity with respect to change in real exchange rate is very low.

Even for those developed countries Marshall-Lerner condition holds, there is a general consensus based on empirical
study that devaluation cause deterioration of current account balance in short run. This is because in the short run price
elasticity of export and import demand is very low and always fail to sum up to one, while in the long run the sum of
price elasticity of demand and supply almost always greater than one.

The idea underlying the J-curve effect is whether the volume effects on imports and exports are sufficiently strong to
outweigh the price effect in the short run and long run. In the short run, export and import volumes don‘t change much,
because of time lag in consumer responses; time lag in producers‘ response and imperfect competition: so that the price
effect leading to deterioration of the current account balance. However, after time lag in the long run, the volume of
export increase and volume of import decline so that the volume effect outweigh the relative price effect, consequently
improve current account balance and move to surplus eventually.

There are various reasons to explain slow responsiveness of export and import volume in the short run and responsive
enough in the long run to overcome the relative price effect:
4.5. Open Economy ISLM-BP Frame Work
The analysis of closed economy ISLM model extended to ISLM BP model by considering the impact of international
capital movement.
4.5.1. Balance of Payment (BOP)
Balance of payment (BOP) is a statistical record of all the economic transaction between home country and the rest of
the world for a specific period, usually one year. BoP account use double bookkeeping principles to record those
international transactions. That is, any transaction involves debit and credit items. As general rule, credit items in BOP
accounts reflect transaction that give rise to payments inward to home country. The major items that are registered as
credit includes exports, foreign directed investment inflow to home country, receipts of interest and dividends by the
home country from earlier investment abroad. These credit items are recorded with plus sign. On the other hand, debit
items in the balance of payment accounts reflect transactions that give rises to payment outward from home country.
The major items are imports, investments made in foreign countries by domestic nationals and payments of interest and
dividends by the home country on earlier investments made by foreign investors. By convention, debit items are
recorded with minus sign.

There are two main accounts in the balance of payment: the current account and the capital account and each of them
subdivided in to other sub account.
Current account
It records trade in goods and services as well as transfers. It includes trade balance (the difference between revenue
received from exports of goods and expenditure on imported of goods) and invisible trade balance (the difference
between revenue received from export services and payment made for import services). Unilateral transfer including
remittances of families in foreign countries, aids, gifts and grants. The current account balance is therefore the sum of
trade balance and the invisible balance. If the balance is negative, the current account is said to be in deficit, whereas it
said to be surplus if the balance is positive.
Capital account
The capital account records transactions concerning the movement of financial capital in to and out of a country.
Capital comes in to a country by borrowing, sales of overseas assets and investment in the country by foreigners. These
items are said to be capital inflow and recorded as credit items while capital that leaves the country due to lending,
buying of overseas assets and purchases of domestic assets owned by foreigner residents. These items represents capital
outflow and recorded as debit. Balance of payment therefore, is the sum of current account became (CA) and capital
account balance (KA).
B
O PC
A K
A

24 | P a g e
Having described the different component of balance of payment, let us discuss factors (variables) which directly and
indirectly affect the performance of balance of payment and its component for a given country.

A rise in exchange rate rise export and a decline in exchange rate cause decline in export assuming Marshall Lerner
condition holds. Thus, we can define export as.

XXY
( f ,e)
X 
X
0
, 0
.

Yf e
Import negatively related to exchange rate and positively related to domestic income
MMY
( d,e)
M M
0, 0
Yd e
C
AX
(Y 
f,)
e M
(
Yd,)
e

C
AC
A(
Yd,
Y f,)
e


CA 
CA CA

0, 0 0
 As
sum
em
ar
sha
l
lLe
rn
erc
ond
i
ti
onh
ol
ds

Yf 
Yd 
e
In summary:

A rise in foreign income improves current account balance through increase domestic demand for goods and
services
A depreciation/devaluation of domestic currency improves current account balance by making export
competitive in the international market.
Rise in domestic income raises import spending and worsen current account balance through decreasing
aggregate demand of a given open economy.
What determines net flow of capital between countries? Capital flow assumed to respond to interest rate
differentials between abroad and domestic countries described as follows
K  k (rr *
),K K IK O Where K- capital account balance (net capital flow), r- domestic interest rate,
r* world interest rate k- interest sensitivity of international capital flow or degree of capital mobility, KI-
capital inflow ,KO-capital outflow
If domestic interest rate is greater than foreign interest rate (r>r*), capital owner gain more return if they
keep their asset in the form of domestic interest bearing asset. This will attract more capital to flow into
the country (increase capital inflow) and makes capital account to become surplus. As a result the inflow
of capital to a domestic country can be described as an increasing function of domestic interest rate and
negative function of the foreign interest rate. On the other hand, a fall in domestic interest rate will attract
capital to other foreign country and increases capital outflow and leads to capital account deficit (net
capital outflow). BoP is said to be at equilibrium when its balance equal to zero. That is the balance of
payment equilibrium requires that any deficit on current account must be offset by equal surplus in the
capital account and vice versa.

4.5.1.1 Derivation of the BOP curve

B
P
CA
(,
Y
dY 
f,)
eK (
rr*
)

25 | P a g e
 BOP curve is a curve that shows the various combinations of income and interest rate that produce
equilibrium balance of payment. It is constructed under the assumption of fixed exchange rate, constant
foreign interest rate, price level, income and expected exchange rate. Mathematically, it is possible to
illustrate that Bop curve is upward sloping in interest rate income space to show positive relationship between
interest rate and income that maintain Bop at equilibrium.
Assuming that exchange rate, foreign income and foreign interest are constant. The slope of Bp curve,
dr k,
 ,
dYd m

K
,
d
o
me
st
i
cin
t
e
re
st
r
at
ea
n
dca
p
i
t
al
Where 
k 
0 

r 
a
c
co
u
nt
ba
la
n
c
ea
rep
os
i
t
i
ve
l
yr
e
la
t
e
d

(m ) K,
M '
 0  0 Which implies BoP curve
Y d Income positively affects import. m
,

is upward sloping.
If the economy is located to the right of BoP curve, then it represents a BoP deficit. On the contrary if an
economy located to the left of the BOP curve, it belongs to BOP surplus.

4.5.2. Factors Shifting the BoP Curve

There are different variables which cause shift in BOP curve by affecting capital account and current account
balance. Some of these variables are autonomous change in import and export, exchange rate and other factors
which affect domestic income and interest rate. These variables cause shift in BOP curve accordingly under
flexible exchange rate regime only. In case of fixed exchange rate regime the BOP curve do not shift
regardless of the degree of capital mobility.
Let us consider how exchange rate change results in shift in BOP curve. Suppose that there is increase in
exchange rate (depreciation of domestic currency). Assuming Marshall Lerner condition holds depreciation of
domestic currency improves current account balance by promoting export and reducing import. At any given
interest rate on BOP curve, there is now a surplus balance of payment hence a larger level of Y is needed for
each i to maintain BOP equilibrium (for a given status of capital account).
4.5.3 Open Economy IS Curve
Like in the case of closed economy IS curve in open economy shows different combination of equilibrium
income and interest rate. However, open economy IS schedule includes net export (NX) as additional
component. Therefore, we can express IS curve as
Y  C (
Y ) I(r
)G  X (Y f )M(Yd,e )
IS:
Y  A(Y ,i) NX (Y f,Y, e)
What causes shifts in IS curve? As in closed-economy model, the IS schedule will be shifted outward to the
right as a result of increase in government expenditure and an autonomous increase in investment. In addition
in case of open economy IS curve shift to the right if there is autonomous increase in export or decrease in
import. Since depreciation or devaluation of exchange rate assuming Marshall-Lerner condition holds increase
in export and decrease import, it causes outward to the right shift in the IS curve. On the other hand
appreciation cause shift in IS curve to the left downward, since it promote import and discourage export.
4.5.4. Open Economy LM Curve

26 | P a g e
Similar to closed economy LM curve, open economy LM curve is upward sloping. As in the case of closed
economy, LM equation can be represented by money market equilibrium where real demand for money
d
M
defined as  K (
Y )L()
r Where K(Y) transaction demand for money and L(r)- speculative demand for
P
money, Real money supply;
(Assumed to be exogenous)Then we can define money market equilibrium as:
s d
M M

p p
_
M
KY
( )Lr
() Lm equation
p
dY
0
dr
What causes open economy LM curve to shifts? LM curve shifts when there is:
Change in money supply
Change in variables such as the status of BOP that affect money supply.(refer macroeconomics
books to see the effect of BoP status on LM curve)
An increase in money supply (expansionary monetary policy) for a given level of interest rate cause downward
shift in LM curve where contractionary monetary policy causes upward shift in LM curve.

4.6. The Mundell-Fleming Model

Mundell-Fleming model (MF) is analytical tool used to make analysis about the impact of monetary and
fiscal policy by incorporating international capital movement to Keynesian closed economy ISLM
framework. The model is used under the following basic assumption;
 The domestic economy is ‗small‘ in relation to the rest of the world: values of word variables (foreign
income, prices and interest rate) are exogenous
 Domestic output is demand determined with its price, p. constant. The economy in demand full
employment so that increase in demand result un expansion output
 The capital account is determined by home and overseas interest rate differential (r-r*)
4.6.1. Monetary and Fiscal Policies under Fixed Exchange Regime
4.6.1.1 Fiscal Policy under Fixed Exchange Rate Regime

The effectiveness of fiscal policy under fixed exchange rate strongly depends on the degree of capital
mobility. When capital is perfectly mobile, fiscal policy is effective in moving the economy‘s equilibrium
level of income and employment to a certain targeted level. But as capital becomes less and less mobile,
fiscal policy becomes less and less effective. Fiscal policy is totally ineffective in fixed exchange rate in case
of perfectly capital immobile case. (Refer different macroeconomics books and modules for detail
explanations)
4.6.1.2. Monetary Policy under Fixed Exchange Rate Regime
Suppose government increases money supply to increase income. Expansionary monetary policy (increase in
money supply) shifts LM curve to the right. In all the three cases, there is formation of a new domestic
equilibrium that lies below or to the right of BP curve. Thus, at new domestic equilibrium the balance of
payments will be in a deficit as lower interest rate induces capital outflows and a higher level of income
induces more import for a given level of exports. This induces pressure on domestic currency to depreciate.
27 | P a g e
The central banks intervene under fixed exchange rate and supply foreign currency at the official rate to
protect the targeted rate as a result money supply reduced unless sterilized. This will cause shift in LM curve
backward to the left to its original position.
Thus, expansionary or contractionary monetary policy has no impact on equilibrium level of income and
employment under fixed exchange rate system (unsterilized). That means monetary policy is completely
ineffective to influence income and employment under a system of fixed exchange rate regardless of the
degree of capital mobility.

4.6.2. Fiscal and Monetary Policy under Flexible Exchange Rate Regime
4.6.2.1. Fiscal Policy under Flexible Exchange Rate

The effectiveness of fiscal policy under flexible exchange rate strongly depends on the degree of capital
mobility. When capital is perfectly immobile, fiscal policy is effective in moving the economy‘s equilibrium
level of income and employment to a certain targeted level. But as capital becomes more and more mobile,
fiscal policy becomes less and less effective. Fiscal policy is totally ineffective in case of perfectly capital
mobile case.(refer different macroeconomics books and modules for detail explanations)
4.6.2.2. Monetary Policy under Flexible Exchange Rate
Increase in money supply causes shift in LM curve downward to the right in all the three cases of capital
mobility. This would expand domestic income and output downward pressure on exchange rate. As a result
balance of payment becomes in deficit in case of flexible exchange rate regime in general. The deficit in BOP
by its turn causes depreciation of domestic currency which accompanied by increase in export and decrease
in imports. This leads to shift in BP and IS curve to the right due to the improvement in international
competitiveness which results in increase in income and strengthening of the trade balance. This shows
monetary policy is effective to change output/income in case flexible exchange rate regardless of the degree
of capital mobility.

CHAPTER FIVE
AGGREGATE SUPPLY ANALYSIS
5.1 INTRODUCTION
Aggregate demand-supply model is a basic tool in macroeconomics to study about output and price
determination. Moreover, the model provides us a way to contrast how the economy behaves in the short and
long run response to monetary and fiscal policies.
5.1.1. AGGREGATE SUPPLY CURVE
To construct the AD-AS model, now let us describe first aggregate supply curve under different assumption.
Aggregate supply curve is a curve which represents the quantities of output firms are willing to supply at
different level of prices. This implies AS curve reflects conditions in factor market (labour market) as well as
goods market. Hence, the slope of aggregate supply curve varies depending up on the nature of prices in
labour market across time horizon. Here are two extreme cases.
Classical or long run aggregate supply curve
For classical, output level produced determined by the amount of input (labour and capital) and available
technology. The amount of input (labour) used on the other hand determined by the labour market

28 | P a g e
equilibrium. Since prices or wages are assumed to be flexible in the long run or according to classical, labour
market work smoothly and quickly to maintain full employment of labour force. If the entire labour force is
being employed, then output cannot raise above its current level even if the prices level rise. Thus, aggregate
supply curve will be vertical at output corresponds to full employment level Y.
Keynesian or short run aggregate curve
Unlike in the long run, in the short run, according to Keynesians, prices (wages) are sticky; as a result prices
will not adjust to change in demand and supply conditions. Firms are supplying any amount of output at a
fixed level of price in extreme cases. That is, aggregate supply curve is not vertical.
The idea underlying the Keynesian aggregate supply curve is that labour market could not clear since prices
are rigid. Hence, the labour market would be characterized by involuntary unemployment always. Therefore,
firms obtain as much labour as they wants at current prices and their average cost of production as a result
assumed to be not changing with their output level. If households are willing to supply as firms can obtain as
much labour as they want at current wage, their average costs of production match with what is demanded at
the existing price level.
5.1.2. Fiscal and Monetary Policy under Alternative Supply Assumption
The Keynesian case
Now consider a fiscal expansion; increase government spending or cut in tax rates expand aggregate demand
in the economy. This shift results in new equilibrium at higher level of output without affecting prices. In
addition, fiscal expansion like in the case of ISLM causes increase interest rate through expanding income
and raising money demand. This may result in crowd out effect on investment.
Similarly, monetary expansion results in expansion of output through the impact it has on interest rate and
increase investment demand, which results in expansion of aggregate demand. This will cause outward shift
in aggregate demand curve forming new equilibrium at higher level of output and employment. Thus, we
conclude that the effect of fiscal and monetary policy in Keynesian case is similar to a simple ISLM model.
The classical supply case
With vertical AS curve an increase in government expenditure or decrease in tax causes an increase aggregate
demand, it causes shift AD, which results in new level of equilibrium at higher level of price without
affecting the full employment level of output. That means at initial level of price Po the demand for goods
has risen. The increase in prices reduces the real money balance and leads to increase in interest rate. This
will result in decline in investment and aggregate spending to a level consistent will full-employment of
output. That is the fiscal stimulus is translated entirely in to higher interest rate and price level without
affecting real variable such as output and employment.
With classical supply model therefore, real variables such as output, employment, real balances and interest
rate are not affected by monetary expansion like the case of fiscal policy. The increased money stock causes
expansion of aggregate demand by decreasing interest rate and increasing investment. The excess aggregate
demand relative to full employment level of aggregate supply pulls the price level up proportionately to the
expansion of money supply. The increase in price level offset the increase in nominal money, leaving the real
money stock unchanged. This implies money is completely neutral in classical case (change in money supply
has no effect on real variables).
5.2. Models of Aggregate Supply
In this section, explain why a short run (Keynesian) aggregate supply curves is upward sloping unlike the
vertical classical or long run aggregate supply curve. There are four different models or theories which
29 | P a g e
explain differently, why the short run and long run aggregate supply curve are different. All of the models
begin their description from the proposition which says, due to some market imperfection the output of the
economy deviates from the classical full employment level of output. That is the supply curve take the form:
Y Y  (pp e
),  0
Where Y is output, Y full employment level of output, P is price level and Pe is the expected price level.
According to the above equation, if actual price deviates from the expected price level, then output deviates
from the natural rate (full employment level). The models that we consider next gives different reason for
unexpected movements in the price levels leads to fluctuation in aggregate level of output from the natural
level.
5.2.1. The Sticky Wage Model
Due to various reasons such as workers are unionized, nominal wages are set by long-term contract, the
efficiency wage argument, the minimum wage legislation and other related factors many economists believe
that nominal wages are sticky or sluggish in the short run.
To begin with, consider what happens to the amount of output produced as the prices rises. Under sticky
nominal wage, a rise in price level lowers the real wages. When real wage lowered, it induces firms to hire
more labour and then the additional labour hired produces more output. Such positive relationship between
the price level and the amount of output when nominal wages are sticky is represented by upward sloping
aggregate supply curve.
Deviation of expected price from actual price results in deviation of real wage from the expected targeted real
wage. Given the above assumption, deviation of targeted real wage from the actual real wage cause the
labour demand and labour supply to change. This results in difference in the level of employment from the
full employment level and leads to deviation of output from full employment level. That is for sticky wage
model, if actual price is greater than expected price, the actual real wage becomes lower than the expected
real wage resulting in increased demand for labour and then employment. An increase in the level of
employment on the other hand expands output above the natural rate. If the actual price is less than expected
price the opposite condition occurs. Thus, output level deviate from natural level when expected price deviate
from actual price and the resulting aggregate supply curve becomes upward sloping represented by the
following equation. Y Y  (pp e
)

5.2.2. Worker Misperception Model

In worker misperception model assumes that wages are flexible to equilibrate demand and supply of labour.
It assumes on the other hand workers confuse temporarily nominal wage with real wage. This confusion
affects the level of employment determined by labour market equilibrium and the output produced.
Therefore, according to workers misperception model the deviation of price from expected price result in
deviation of output from its natural rate, which would result in upward sloping aggregate supply curve of the
form:

YY(pp
e
)

In other words, for a given level of labour demand, unexpected increase in price cause real wage decline.
This will cause increase labour supply which result in increased level of employment and output.
5.2.3. Imperfect- Information Model

30 | P a g e
Similar to worker misperception model, imperfect information model assumes the flexibility of wages to
clear labour market and short run aggregate supply curve is the result of misperception of prices. However,
the model does not differentiate between workers and firms in terms of price expectation.
The model assumes that each supplier in the economy produce a single product and consume many goods.
Because of the number of goods consumed is so large, supplier cannot observe all prices at all time. They
closely monitor the price of what they produce. Because of lack of information (imperfect information), they
sometimes confuse change in the overall level of prices with change in relative prices. That is, firms make
production decision by estimating their relative real price based on their nominal price and expected overall
price. When their nominal price increases because of increase in general price, firms take as if their relative
price increase. Producers, therefore, infers unexpected rise in nominal prices of their product as if there is a
rise in relative price due to lack of information. Such confusion influence decision about how much to supply
and leads to short run relationship between price and output.
5.2.4. Sticky Price Model
The sticky price model emphasizes that firms do not instantly adjust the prices they charge in response to
changes in demand. Sometimes prices are set by long-term contracts between firms and customers. Even
without formal agreements, firms may hold prices steady in order not to annoy their regular customers with
frequent price changes. Some prices are sticky because of the way markets are structured: once a firm has
printed and distributed its catalogue or price list, it is costly to alter prices.
In reality, firms generally set the prices at which they want to sell their output. To analyse this situation
properly, we need models of imperfect competition in which firms have some monopoly power.
Consider the pricing decision facing a typical firm. Firms desired price p determination depends on two
macroeconomic variables:
The overall price, and level of aggregate income,
Hence, firms‘ price determination as a function of overall price and the level of income (output) relative to
the natural rate can be expressed as
Pa (Y Y)
Where P-overall price, P-desired price of firms, Y  Y -the deviation of output from the natural rate and a-
parameter greater than zero.
Now assume that there are two types of firms in the economy. Those with flexible prices and set their price
according to the above equation and those with sticky price which set their price base on expected economic
conditions as indicated with the following equation:
P   e
 a (Ye
 Y e
)Where e represents the expected value of the variables.
P  e
 (Y Y )
The terms in this equation show that: When firms expect higher prices due to higher cost of production, they
have the desire to set their actual price at higher level. When output is high, the demand for goods is high.
Those firms with flexible prices set their prices high, which leads to a high price level. The effect of output
on the price level depends on the proportion of firms with flexible prices. Hence, the overall price level
depends on the expected price level and on the level of output.
Rearranging the above price equation, we can derive the aggregate supply equation
Y Y (P  e)
Like the other three model, the sticky price model also indicate that, the deviation of output from the natural
rate is the result of deviation of expected price from the actual prices.
31 | P a g e
 Macroeconomics II
CHAPTER ONE
CONSUMPTION AND SAVING
From the first part of this course we know that we study macroeconomics to understand how the aggregate
economy behaves. We also know that understanding the behaviour of aggregate output is crucial in achieving
this objective and that the ‗‘bits‘‘ of output that we need to know something about are contained in the
national income accounting identity Y=C+I+G+EX-IM. The component of this identity is consumption by
households, which also makes up the largest part of GDP. As a result, we cannot hope to understand what
determines the long run path of GDP, or the short run fluctuations of GDP, without understanding how
consumption and savings are determined.
Therefore, how do households decide how much of their income to consume today and how much to save for
the future is a central question in the economics of consumption and saving. This is a microeconomic
question because it addresses the behaviour of individual‘s decision makers. Yet its answer has a
macroeconomic consequence since household‘s consumption decisions after the way the economy as a whole
behaves both in the long run and in the short run. You will see in the next chapter how the consumption
decision is crucial for long run analysis because of its role in determining economic growth.
The consumption decision is crucial for short run analysis because of its role in determining aggregate
demand. We have seen in our discussion of macroeconomics I how the IS-LM model shows a change in
consumer‘s spending plans can be a source of shocks to the economy, and that marginal propensity to
consume is a determinant of the fiscal policy multipliers.
In this chapter we examine the consumption function in greater detail and develop a more thorough
explanation of what determines aggregate consumption. To understand this attempt will be made to present
the views of five prominent economists namely, John Maynard Keynes, Irving Fisher, Franco Modigliani,
Milton Freidman and Robert Hall so that it is possible to see the diverse approaches to explaining
consumption.

1.1 John Maynard Keynes's General Theory

Keynes made the consumption function central to his theory of economic fluctuations, and it has played a key
role in macroeconomic analysis ever since. Let's consider what Keynes thought about the consumption
function, and then see what puzzles arose when his ideas were confronted with the data.
Keynes's Conjectures
Instead of relying on statistical analysis, Keynes made conjectures about the consumption function based on
introspection and casual observation.
First: Keynes conjectured that the marginal propensity to consume (the amount consumed out of an
additional unit of income) is between zero and one. His reason was that men are disposed to increase their
consumption as their income increases, but not by as much as the increase in their income. That is, when a
person earns an extra unit of income, he typically spends some of it and saves some of it.
Second, Keynes posited that the ratio of consumption to income, called the average propensity to consume,
falls as income rises. He believed that saving was a luxury, so he expected the rich to save a higher
proportion of their income than the poor.
32 | P a g e
Third, Keynes thought that income is the primary determinant of consumption and that the interest rate does
not have an important role. This conjecture stood in stark contrast to the beliefs of the classical
economists who preceded him. The Classical economists held that a higher interest rate encourages saving
and discourages consumption.
Figure 1.1: The Keynesian consumption function

On the basis of these three conjectures, the Keynesian consumption function is often written as
C ̅ cY where ̅ c
̅
where C is consumption, Y is disposable income, is a constant, and c is the marginal propensity to
consume.
Notice that this consumption function exhibits the three properties that Keynes posited. It satisfies Keynes's
first property because the marginal propensity to consume c is between zero and one, so that higher income
leads to higher consumption and also to higher saving. This consumption function satisfies Keynes's second
property because the average propensity to consume APC is
APC C/Y ̅ /Y c.
̅
As Y rises, /Y falls, and so the average propensity to consume C/Y falls. And finally, this consumption
function satisfies Keynes's third property because the interest rate is not included in this equation as a
determinant of consumption.
Keynesian consumption function and Empirical Successes
Soon after Keynes proposed the consumption function, economists began collecting and examining data to
test his conjectures. In some of these studies, researchers surveyed households and collected data on
consumption and income.
They found that households with higher income consumed more, which confirms that the marginal
propensity to consume is greater than zero. They also found that households with higher income saved
more, which confirms that the marginal propensity to consume is less than one. In addition, these
researchers found that higher-income households saved a larger fraction of their income, which
confirms that the average propensity to consume falls as income rises. Thus, these data verified
Keynes‘s conjectures about the marginal and average propensities to consume.
In other studies, researchers examined aggregate data on consumption and income for the period between the
two world wars. These data also supported the Keynesian consumption function. In years when income was
unusually low, such as during the depths of the Great Depression, both consumption and saving were low,
indicating that the marginal propensity to consume is between zero and one. In addition the ratio of
consumption to income was high, confirming Keynes's second conjecture. Finally, because the correlation
between income and consumption was so strong. Thus, the data also confirmed Keynes's third conjecture that
income is the primary determinant of how much people choose to consume.
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle
Although the Keynesian consumption function met with early successes, two anomalies soon arose. Both
concern Keynes's conjecture that the average propensity to consume falls as income rises.
On the basis of the Keynesian consumption function, these economists reasoned that as incomes in the
33 | P a g e
economy grew over time, households would consume a smaller and smaller fraction of their incomes. They
feared that there might not be enough profitable investment projects to absorb all this saving. If so, the low
consumption would lead to an inadequate demand for goods and services, resulting in a depression once the
wartime demand from the government ceased. In other words, on the basis of the Keynesian consumption
function, these economists predicted that the economy would experience what they called secular stagnation
a long depression of indefinite duration unless fiscal policy was used to expand aggregate demand.
Fortunately for the economy, but unfortunately for the Keynesian consumption function, the end of World
War II did not throw the country into another depression. Although incomes were much higher after the war
than before, these higher incomes did not lead to large increases in the rate of saving. Keynes's conjecture
that the average propensity to consume would fall as income rose appeared not to hold.
The second anomaly arose when economist Simon Kuznets constructed new aggregate data on consumption
and income dating back to 1869. He discovered that the ratio of consumption to income was remarkably
stable from decade to decade, despite large increases in income over the period he studied. Again, Keynes's
conjecture that the average propensity to consume would fall as income rose appeared not to hold.
The failure of the secular-stagnation hypothesis and the findings of Kuznets both indicated that the APC is
fairly constant over long periods of time.
Figure 1-2 illustrates the puzzle. The evidence suggested that there were two consumption functions. For the
household (short time-series) data, the Keynesian consumption function appeared to work well. Yet for the
long time- series, the consumption function appeared to have a constant average propensity to consume.
Figure 1.2: The consumption puzzle

1.2 Irving Fisher and Inter-temporal Choice

The consumption function introduced by Keynes relates current consumption to current income. This
relationship, however, is incomplete. When people decide how much to consume and how much to save, they
consider both the present and the future.
The economist Irving Fisher developed the model with which economists analyse how rational, forward-
looking consumers make Inter-temporal choice.
The Inter-temporal Budget Constraint
Consumers face a limit on how much they can spend, called a budget constraint. When they are deciding how
much to consume today versus how much to save for the future, they face an Inter-temporal budget
constraint, which measures the total resources available for consumption today and in the future. Our first
step in developing Fisher's model is to examine this constraint in some detail.
To keep things simple, we examine the decision facing a consumer who lives for two periods. Period one
represents the consumer's youth and period two represents the consumer's old age. The consumer earns
income Y1 and consumes C1 in period one, and earns income Y2 and consumes C2 in period two. Because
the consumer has the opportunity to borrow and save, consumption in any single period can be either greater
or less than income in that period.
Consider how the consumer's income in the two periods constrains consumption in the two periods.
In the first period, saving equals income minus consumption. That is,
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 S Y1  C1,
Where S is saving. In the second period, consumption equals the accumulated saving, including the interest
earned on that saving, plus second-period income. That is,
C2 r) S Y2,
Where r is the real interest rate. For example, if the interest rate is 5 percent, then for every $1 of saving in
period one, the consumer enjoys an extra $1.05 of consumption in period two. Because there is no third
period, the consumer does not save in the second period.
Note that the variable S can represent either saving or borrowing and that these equations hold in both
cases.
 If first-period consumption is less than first period income (C1<Y1), the consumer is saving, and S is
greater than zero.
 If first-period consumption exceeds first-period income (C1>Y1), the consumer is borrowing, and S is
less than zero. For simplicity, we assume that the interest rate for borrowing is the same as the interest
rate for saving.
This equation relates consumption in the two periods to income in the two periods. It is the standard way of
expressing the consumer's inter-temporal budget constraint.
The consumer's budget constraint is easily interpreted.
 If the interest rate is zero, the budget constraint shows that total consumption in the two
periods equals total income in the two periods.
 In the usual case in which the interest rate is greater than zero, future consumption and future income
are discounted by a factor
Figure 1.3 graphs the consumer's budget constraint. Three points are marked on this figure.
 At point A, the consumer consumes exactly his income in each period (C1 Y1 and C2 = Y2), so
there is neither saving nor borrowing between the two periods.
 At point B, the consumer consumes nothing in the first period (C1
second-period consumption C2 r)Y1 Y2.
 At point C, the consumer plans to consume nothing in the second period (C2 and borrows as
much as possible against second-period income, so first-period consumption C1 is Y1 Y2 r).
Figure 1.3: The Consumer’s Budget Constraint

1.3 Franco Modigliani and the Life-Cycle Hypothesis

Modigliani emphasized that income varies systematically over people's lives and that saving allows
consumers to move income from those times in life when income is high to those times when it is low. This
interpretation of consumer behaviour formed the basis for his life-cycle hypothesis.
The Hypothesis
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One important reason that income varies over a person's life is retirement. Most people plan to stop working
at about age 65, and they expect their incomes to fall when they retire. Yet they do not want a large drop in
their standard of living, as measured by their consumption. To maintain consumption after retirement, people
must save during their working years. Let's see what this motive for saving implies for the consumption
function.
Consider a consumer who expects to live another T years, has wealth of W, and expects to earn income Y
until he/she retires R years from now. What level of consumption will the consumer choose if he/she wishes
to maintain a smooth level of consumption over his/her life?
The consumer's lifetime resources are composed of initial wealth W and lifetime earnings of R Y. The
consumer can divide up his/her lifetime resources among her T remaining years of life. We assume that
he/she wishes to achieve the smoothest possible path of consumption over his/ her lifetime. Therefore, he/she
divides this total of W RY equally among the T years and each year consumes
C W RY)/T.
We can write this person's consumption function as
C T R/T) Y.
For example, if the consumer expects to live for 50 more years and work for 30 of them, then T
R
C W Y.
This equation says that consumption depends on both income and wealth. An extra $1 of income per year
raises consumption by $0.60 per year, and an extra $1 of wealth raises consumption by $0.02 per year.
If every individual in the economy plans consumption like this, then the aggregate consumption function is
much the same as the individual one. In particular, aggregate consumption depends on both wealth and
income. That is, the economy's consumption function is
C W Y,
Where the parameter is the marginal propensity to consume out of wealth, and
propensity to consume out of income the parameter.
Figure 1.4: The life cycle consumption function

Implications
Figure 1.4 graphs the relationship between consumption and income predicted by the life-cycle model. For
any given level of wealth W, the model yields a conventional consumption function similar to the one shown
in Figure 1.1.
Notice, however, that the intercept of the consumption function, which shows what would happen to
consumption if income ever fell to zero, is not a fixed value, as it is in Figure 1.1. Instead, the intercept
here is W and, thus, depends on the level of wealth.
This life-cycle model of consumer behaviour can solve the consumption puzzle. According to the life-cycle
consumption function, the average propensity to consume is

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 C /Y W/Y
Because wealth does not vary proportionately with income from person to person or from year to year, we
should find that high income corresponds to a low average propensity to consume when looking at data
across individuals or over short periods of time. But, over long periods of time, wealth and income grow
together, resulting in a constant ratio W/Y and thus a constant average propensity to consume.
To make the same point somewhat differently, consider how the consumption function changes over time. As
Figure 1.4 shows, for any given level of wealth, the life-cycle consumption function looks like the one
Keynes suggested. But this function holds only in the short run when wealth is constant. In the long run, as
wealth increases, the consumption function shifts upward, as in Figure 1.5. This upward shift prevents the
average propensity to consume from falling as income increases. In this way, Modigliani resolved the
consumption puzzle posed by Simon Kuznets's data.
The life-cycle model makes many other predictions as well. Most important, it predicts that saving varies
over a person's lifetime. If a person begins adulthood with no wealth, he/she will accumulate wealth during
his/her working time.
Figure 1.5: the effect of change in wealth on consumption function

Figure 1.6 illustrates the consumer's income, consumption, and wealth over her adult life. According to the
life-cycle hypothesis, because people want to smooth consumption over their lives, the young who are
working save, while the old who are retired dis-save.
Figure 1.6: consumption, income, and wealth over the life cycle

1.4 Milton Friedman and the Permanent-Income Hypothesis

In a book published in 1957, Milton Friedman proposed the permanent income hypothesis to explain
consumer behaviour. Friedman's permanent income hypothesis complements Modigliani‘s life-cycle
hypothesis: both use Irving Fisher's theory of the consumer to argue that consumption should not depend on
current income alone. But unlike the life-cycle hypothesis, the permanent-income hypothesis emphasizes that
people experience random and temporary changes in their incomes from year to year.

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The Hypothesis
Friedman suggested that we view current income Y as the sum of two components, permanent income Y P
and transitory income Y T.That is,
Y YP Y T.
Permanent income: is the part of income that people expect to persist into the future.
Transitory income: is the part of income that people do not expect to persist.
Put differently, permanent income is average income, and transitory income is the random deviation from
that average.
To see how we might separate income into these two parts, consider these examples:
 Haftom, who has a law degree, earned more this year than Yohannes, who is a high-school dropout.
Haftom's higher income resulted from higher permanent income, because his education will continue
to provide him a higher salary.
 Kasim, a Harar orange grower, earned less than usual this year because a freeze destroyed his crop.
Ali, an Awash orange grower, earned more than usual because the freeze in Harar drove up the price
of oranges. Ali's higher income resulted from higher transitory income, because he is no more likely
than Kasim to have good weather next year.
These examples show that different forms of income have different degrees of persistence. A good education
provides a permanently higher income, whereas good weather provides only transitorily higher income.
Although one can imagine intermediate cases, it is useful to keep things simple by supposing that there are
only two kinds of income: permanent and transitory. Friedman reasoned that consumption should depend
primarily on permanent income, because consumers use saving and borrowing to smooth consumption in
response to transitory changes in income. For example, if a person received a permanent raise of $10,000 per
year, his consumption would rise by about as much. Yet if a person won $10,000 in a lottery, he would not
consume it all in one year. Instead, he would spread the extra consumption over the rest of his life. Assuming
an interest rate of zero and a remaining life span of 50 years, consumption would rise by only $200 per year
in response to the $10,000 prize. Thus, consumers spend their permanent income, but they save rather than
spend most of their transitory income.
Friedman concluded that we should view the consumption function as approximately C Y P,
-
income hypothesis, as expressed by this equation, states that consumption is proportional to permanent
income.
Implications
The permanent-income hypothesis solves the consumption puzzle by suggesting that the standard Keynesian
consumption function uses the wrong variable. According to the permanent-income hypothesis, consumption
depends on permanent income. Friedman argued that this errors-in-variables problem explains the seemingly
contradictory findings.
Let's see what Friedman's hypothesis implies for the average propensity to consume. Divide both sides
of his consumption function by Y to obtain
APC C/Y Y P/Y.
According to the permanent-income hypothesis, the APC depends on the ratio of permanent income
to current income. When current income temporarily rises above permanent income, the average propensity
to consume temporarily falls; when current income temporarily falls below permanent income, the average
propensity to consume temporarily rises.
Households with high permanent income have proportionately higher consumption. If all variation in current
income came from the permanent component, the average propensity to consume would be the same
in all households. But some of the variation in income comes from the transitory component, and

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households with high transitory income do not have higher consumption. Therefore, researchers find that
high-income households have, on average, lower average propensities to consume.

Similarly, consider the studies of time-series data. Friedman reasoned that year-to-year fluctuations in
income are dominated by transitory income. Therefore, years of high income should be years of low
average propensities to consume. But over long periods of time say, from decade to decade the variation
in income comes from the permanent component. Hence, in long time-series, one should observe a
constant APC.

1.5. The Random-Walk Hypothesis

It is developed by Robert Hall (1978) based on Fisher‘s model & PIH, in which forward-looking consumers
base consumption on expected future income. Hall adds the assumption of rational expectations, that people
use all available information to forecast future variables like income.
If PIH is correct and consumers have rational expectations, then consumption should follow a random walk:
changes in consumption should be unpredictable. A change in income or wealth that was anticipated has
already been factored into expected permanent income, so it will not change consumption. Only
unanticipated changes in income or wealth that alter expected permanent income will change consumption.
Implication of the R-W Hypothesis
If consumers obey the PIH and have rational expectations, then policy changes will affect consumption only
if they are unanticipated.
 The R-W Hypothesis implies that consumption will respond only if consumers had not anticipated the
tax cut.
CHAPTER TWO
INVESTMENT SPENDING
Investment is the most volatile component of GDP. When expenditure on goods and services falls during a recession,
much of the decline is usually due to a drop in investment spending.
There are three types of investment spending.
1. Business fixed investment includes the equipment and structures that businesses buy to use in production.
2. Residential investment includes the new housing that people buy to live in and that landlords buy to rent out,
3. Inventory investment includes those goods that businesses put aside in storage, including materials and supplies,
work in process, and finished goods.
We build models of each type of investment to explain these fluctuations. As we develop the models, it is useful to
keep in mind the following three questions:
 Why investment is negatively related to the interest rate?
 What causes the investment function to shift?
 Why does investment rise during booms and fall during recessions?

2.1 Business Fixed Investment

The standard model of business fixed investment is called the neoclassical model of investment. The neoclassical
model examines the benefits and costs to firms of owning capital goods. The model shows how the level of investment
– the addition to the stock of capital-is related to the MPK, the interest rate, and the tax rules affecting firms.
To develop the model, there are two kinds of firms in the economy.
 Production firms produce goods and services using capital that they rent.
 Rental firms make all the investments in the economy; they buy capital and rent it out to the production firms.

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Of course, most firms in the actual economy perform both functions: they produce goods and services, and they invest
in capital for future production. Our analysis is simple; however, if we separate these two activities by imagining that
they take place in different firms.

The Rental Price of Capital /Production Firm/

The firm decides how much capital to rent by comparing the cost and benefit of each unit of capital. The firm rents
capital at a rental rate R and sells output at a price P; the real cost of a unit of capital to the production firm is R/P. The
real benefit of a unit of capital is the MPK -the extra output produced with one more unit of capital. The MPK declines
as the amount of capital rises: the more capital the firm has, the less an additional unit of capital will add to its
production.

To maximize profit, the firm rents capital until the MPK equal the real rental price. The MPK determines the demand
curve. At any point in time, the amount of capital in the economy is fixed, so the supply curve is vertical. The real
rental price of capital adjusts to equilibrate supply and demand.

To see what variables influence the equilibrium rental price, it is instructive to consider a particular production
function. Many economists consider the Cobb-Douglas production function a good approximation of how the actual
economy turns capital and labor into goods and services. The Cobb-Douglas production function is
Y = AKaL1-a
where Y is output, K capital, L labor, A a parameter measuring the level of technology, and a, a parameter between
zero and one that measures capital's share of output. The MPK for the Cobb-Douglas production function is MPK =
aA(L/K)1-a
Because the real rental price equals the MPK in equilibrium, we can write
R/P = aA(L/K)1-a
This expression identifies the variables that determine the real rental price. It shows:
 The lower the stock of capital, the higher the real rental price of capital
 The greater the amount of labor employed, the higher the real rental price of capital
 The better the technology, the higher the real rental price of capital
Events that reduce the capital stock (an earthquake), or rise employment (an expansion in AD), or improve the
technology (a scientific discovery) rise the equilibrium real rental price of capital.
The Cost of Capital /Rental Firm/
These firms like car-rental companies, merely buy capital goods and rent them out. Since our goal is to explain the
investment made by the rental firms, we begin by considering the benefit and cost of owning capital.
The benefit of owning capital is the revenue from renting it to the production firms. The rental firm receives the real
rental price of capital, R/P, for each unit of capital it owns and rents out.
The rental firm bears three costs:
1. If the firm borrows to buy the capital, it must pay interest. If PK is the purchase price of a unit of capital, and i is the
nominal interest rate, then iPK is the interest cost.
2. If the price of capital falls, the firm loses, because the firm's asset has fallen in value. If the price rises, the firm
gains. The cost of this loss or gain is -  PK.
3. If  is the rate of depreciation-the fraction of value lost per period due to wear and tear-then the dollar cost of
depreciation is  PK.
The total cost of renting out a unit of capital for one period is therefore
Cost of Capital = iPK -  PK +  PK
= PK(i -  PK /PK +  )
The cost of capital depends on the price of capital, the interest rate, the rate at which capital prices are changing, and
the depreciation rate. See an example from Debre Brihan University module
To make the expression for the cost of capital simpler and easier to interpret, we assume that the price of capital goods
rises with the prices of other goods. In this case,  PK /PK equal the overall rate of inflation  . Because i -  equals the
real interest rate r, we can write the cost of capital as
Real Cost of Capital = (PK/P)(r +  )
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This equation states that the real cost of capital depends on the relative price of a capital good PK/P, the real interest rate
r, and the depreciation rate  .
The determinants of investment

Now consider a rental firm's decision about whether to increase or decrease its capital stock. For each unit of capital,
the firm earns real revenue R/P and bears the real cost (PK/P)(r +  ). The real profit per unit of capital is
Profit Rate = Revenue - Cost
= R/P - (PK/P)(r +  )
Since the real rental price in equilibrium equals the MPK, we can write the profit rate as
Profit Rate = MPK - (PK/P) (r +  )
The rental firm makes a profit if the MPK is greater than the cost of capital. It incurs a loss if the MP K is less than the
cost of capital.

We can now see the economic incentives that lie behind the rental firm's investment decision. The firm's decision
regarding its capital stock - that is, whether to add to it or to let it depreciate - depends on whether owning and renting
out capital is profitable. The change in the capital stock, called net investment, depends on the difference between the
MPK and cost of capital. If the MPK exceeds the cost of capital, firms find it profitable to add to their capital stock. If
the MPK falls short of the cost of capital, they let their capital stock shrink. (for detail explanation see N. Gregory
Mankiw Macroeconomics book)

Taxes and Investment

The tax laws influence firms' incentives to accumulate capital in many ways. Sometimes policymakers change the tax
laws in order to shift the investment function and influence aggregate demand. Here we consider two of the most
important provisions of corporate taxation: the corporate income tax and the investment tax credit.
The effect of a corporate income tax on investment depends on how the law defines "profit" for the purpose of
taxation. One major difference is the treatment of depreciation. In periods of inflation, replacement cost is greater than
historical cost, so the corporate tax tends to understate the cost of depreciation and overstate profit. As a result, the tax
law sees a profit and levies a tax even when economic profit is zero, which makes owning capital less attractive. For
this and other reasons, many economists believe that the corporate income tax discourages investment.

The investment tax credit is a tax provision that encourages the accumulation of capital. The investment tax credit
reduces a firm's taxes by a certain amount for each dollar spent on capital goods. Because a firm recoups part of its
expenditure on new capital in lower taxes, the credit reduces the effective purchase price of a unit of capital P K. Thus,
the investment tax credit reduces the cost of capital and raises investment.

The Stock Market and Tobin's Q

Many economists see a link between fluctuations in investment and fluctuations in the stock market. The term stock
refers to the shares in the ownership of corporations, and the stock market is the market in which these shares are
traded. Stock prices tend to be high when firms have many opportunities for profitable investment, since these profit
opportunities mean higher future income for the shareholders. Thus, stock prices reflect the incentives to invest.

The Nobel-Prize-winning economist James Tobin proposed that firms base their investment decisions on the following
ratio, which is now called Tobin's q:

Market value of installed capital

Q=
Re plecement Cost of Installed Capital

Market Value of Installed Capital - value of the economy's capital as determined by the stock market.
Replacement Cost of Installed Capital - the price of the capital if it were purchased today.
Tobin reasoned that net investment should depend on whether q is greater or less than one.

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 The connection of Tobin's q with neoclassical model comes from the observation that Tobin's q depends on current and
future expected profits from installed capital. If the MPK exceeds the cost of capital, then installed capital is earning
profits. These profits make the rental firms desirable to own capital, which raises the market value of these firms' stock,
implying a high value of q. the reverse is true when the MPK falls short of the cost of capital.
The advantage of Tobin's q as a measure of the incentive to invest is that it reflects the expected future profitability of
capital as well as the current profitability.

Tobin's q theory provides a simple way of interpreting the role of the stock market in the economy. Suppose, for
example, that you observe a fall in stock prices. Because the replacement cost of capital is fairly stable, a fall in the
stock market usually implies a fall in Tobin's q. A fall in q reflects investors' pessimism about the current or future
profitability of capital. According to q theory, the fall in q will lead to a fall in investment, which could lower aggregate
demand. In essence, q theory gives a reason to expect fluctuations in the stock market to be closely tied to fluctuations
in output and employment.

2.2 Residential Investment

In this section we consider the determinants of residential investment.
Residential investment includes the purchase of new housing both by people who plan to live in it themselves and by
landlords who plan to rent it to others. To keep things simple, however, it is useful to imagine that all housing is owner-
occupied.

The stock equilibrium and the flow supply

There are two parts to the model. First, the market for the existing stock of houses determines the equilibrium housing
price. Second, the housing price determines the flow of residential investment.

The relative price of housing PH/P is determined by the supply and demand for the existing stock of houses. At any
point in time, the supply of houses is fixed. The relative price of housing determines the supply of new houses.
Construction firms buy materials and hire labor to build houses, and then sell the houses at the market price. Their costs
depend on the overall price level P, and their revenue depends on the price of houses P H. The higher the relative price
of housing, the greater the incentive to build houses and the more houses are built. The flow of new houses-residential
investment-therefore depends on the equilibrium price set in the market for existing houses.

According to this model of the housing market, residential investment depends on the relative price of housing. The
relative price of housing, in turn, depends on the demand for housing, which depends on the imputed rent that
individuals expect to receive from their housing. Hence, the relative price of housing plays much the same role for
residential investment as Tobin's q does for business fixed investment.

Changes in Housing Demand

When the demand for housing shifts, the equilibrium housing price changes, which in turn affects residential
investment. The demand curve for housing can shift for various reasons. An economic boom raises national income and
therefore the demand for housing. A large increase in the population, perhaps due to immigration, also raises the
demand for housing.

One of the most important determinants of housing demand is the real interest rate. Many people take out loans-
mortgages-to buy their homes; the interest rate is the cost of the loan. Even the few people who do not have to borrow
to purchase a home will respond to the interest rate, because the interest rate is the opportunity cost of holding their
wealth in housing rather than putting it in a bank. A reduction in the interest rate therefore raises housing demand,
housing prices, and residential investment.
The Tax Treatment of Housing
Just as the tax laws affect the accumulation of business fixed investment, they affect the accumulation of residential
investment. In this case, however, their effects are nearly the opposite. Rather than discouraging investment, as the
corporate income tax does for business, the personal income tax encourages households to invest in housing.

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2.3 Inventory Investment
Inventory investment is one of the smallest components of spending, averaging about 1% of GDP. Yet its remarkable
volatility makes it important. In recessions, inventory investment becomes negative because firms stop replenishing
their inventory as goods are sold. In a typical recession, more than half the fall in spending comes from a decline in
inventory investment.

Reasons for Holding Inventories

Inventories serve many purposes. Before presenting a model to explain fluctuations in inventory investment, let's
discuss some of the motives firms have for holding inventories.

One use of inventories is to smooth the level of production over time. Consider a firm that experiences temporary
booms and busts in sales. Rather than adjusting production to match the fluctuations in sales, it may be cheaper to
produce goods at a steady rate. When sales are low, the firm produces more than it sells and puts the extra goods into
inventory. When sales are high, the firm produces less than it sells and takes goods out of inventory. This motive for
holding inventories is called production smoothing.

A second reason for holding inventories is that they may allow a firm to operate more efficiently. Retail stores, for
example, can sell merchandise more effectively if they have goods on hand to show to customers. Manufacturing firms
keep inventories of spare parts in order to reduce the time that the assembly line is shut down when a machine breaks.
In some ways, we can view inventories as a factor of production: the larger the stock of inventories a firm holds, the
more output in can produce.

A third reason for holding inventories is to avoid running out of goods when sales are unexpectedly high. Firms often
have to make production decisions before knowing how much customers will demand. For example, a publisher must
decide on how many copies of a new book to print before knowing whether the book will be popular. If demand
exceeds production and there are no inventories, the good will be out of stock for a period, and the firm will lose sales
and profit. Inventories can prevent this from happening. This motive for holding inventories is called stock-out
avoidance.

A fourth explanation of inventories is dictated by the production process. Many goods require a number of steps in
production and, therefore, take time to produce. When a product is only partly completed, its components are counted
as part of a firm's inventory. These inventories are called work in process.

The Accelerator Model of Inventories

This model was developed about half a century ago, and it is sometimes applied to all types of investment. Here we
apply it to the type for which it works best-inventory investment.

The model assumes that firms hold a stock of inventories that is proportional to the firms' level of output. There are
various reasons for this assumption. When output is high, manufacturing firms need more materials and supplies on
hand, and they have more goods in the process of being completed. When the economy is booming, retail firms want to
have more merchandise on the shelves to show customers. This assumption implies that if N is the stock of inventories
and Y is output, then,

N = BY, where B is a parameter reflecting how much inventory firms wish to hold as a proportion of output.

Inventory investment I is the change in the stock of inventories change in N.

Therefore, I =  N = B  Y.

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The accelerator model predicts that inventory investment will be proportional to the change in output. When output
rises, firms want to hold more inventories, so they invest in them. When output falls, firms want to hold fewer
inventories, so they allow their inventories to run down.

Inventories and the Real interest rate

Inventory investment depends on the real interest rate. When a firm holds a good in inventory and sells it tomorrow,
rather than selling it today, it gives up the interest it could have earned between today and tomorrow. Thus, the real
interest rate measures the opportunity cost of holding inventories. When the real interest rate rises, holding inventories
becomes more costly, so rational firms try to reduce their stock. Therefore, an increase in the real interest rate depresses
inventory investment. Conclusion

The purpose of this chapter has been to examine the determinants of investment in more detail. Looking back on the
various models of investment, three themes arise.

First, we have seen that all types of investment spending are inversely related to the real interest rate. A higher interest
rate raises the cost of capital to firms that invest in plant and equipment, raises the cost of borrowing to home-buyers,
and raises the cost of holding inventories. Thus, the models of investment developed here justify the investment
function we have used throughout this book.

Second, we have seen what can cause the investment function to shift. An improvement in the available technology
raises the MPK and raises business fixed investment. An increase in the population raises the demand for housing and
raises residential investment. Most important, various economic policies, such as changes in the investment tax credit
and the corporate income tax, alter the incentives to invest and thus shift the investment function.

Third, we have learned why investment is so volatile over the business cycle: investment spending depends on the
output of the economy as well as on the interest rate. In the neoclassical model of business fixed investment, higher
employment raises the MPK and the incentive to invest. Higher income also raises the demand for houses, which raises
housing prices and residential investment. Higher output raises the stock of inventories firms wish to hold, stimulating
inventory investment. Our models predict that an economic boom should stimulate investment, and a recession should
depress it. This is exactly what we observe.

CHAPTER THREE
MONEY DEMAND AND MONEY SUPPLY
3.1. Money Demand
The demand for money arises from the important functions performed by money, such as units of account,
store of value and medium of exchange. Money as a unit of account does not by itself generate any demand
for money, because one can quote prices in dollars without holding any. By contrast, money can serve its
other two functions only if people hold it.
The demand for money as explained by the famous quantity theory assumes that the demand for real balances
is proportional to income. That is: (M/P)d = kY, Where, k is a constant.
However, more general and realistic money demand function assumes that the demand for real balances
depends on both the interest rate and income; (M/P)d = L(i,Y).
Theories of money demand emphasize the role of money either as a store of value or as a medium of
exchange. Theories of money demand that emphasizes the role of money as a store of value are called
‗portfolio theories.

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3.1.1. The Quantity Theory of Money (Transaction Theories of Money Demand)
Theories of money demand that emphasizes the role of money as a medium of exchange are called
‗transactions theories.
1. Fisher’s version:
Irving Fisher‗s version of the quantity theory can be explained in terms of the following equation of
exchange: MV = PT
Where M is the nominal stock of money in circulation and V is the transactions velocity of circulation of
money (i.e the average number of times the given quantity of money changes hands in transactions); P is the
average price of all transactions and T is the number of transactions that take place during the time period.
Both MV and PT measure the total value of transactions during the time period and so must be identical by
assuming money supply is determined by monetary authorities, number of transaction and V are fixed in
short run(since V depends largely on institutional factors (such as whether workers are paid weekly or
monthly)
With T and V constant, the identity can be written as follows: MV = PT.
It shows that changes in M will cause proportionate changes in P; notice that the direction of causation runs
from changes in the stock of money to changes in the general price level.
According to the quantity theory, money is held only for the purpose of making payments for current
transactions. Thus, the demand for money is called a transactions demand. When the money supply is
increased, people find themselves holding more than they need for current transactions and attempt to spend
the excess.
3.1.2. Cambridge version (cash-balance approach)
A version of quantity theory concentrates on the factors that determine the demand for money was developed
by economists at the University of Cambridge. These economists agreed that an individual‗s demand for cash
balances (or nominal money) is proportional to the individual‗s money income. If this were true of all
individuals, then the aggregate demand for money (MD) could be written as proportional to money national
income (Y):
MD = kY, Where; k is a constant.
Notice that Y in this version represents the money value of spending on all final goods and
services produced during the time period. This is much moreover than Fisher‗s versions of the value of all
transactions (PT) which included spending on intermediate goods and financial assets, as well as final goods
and services.
Thus, both the Fisher and Cambridge versions of the quantity theory come to the same important conclusion
that an increase in the money supply leads directly to an increase in spending and, with full employment, the
general price level is proportional to the quantity of money in circulation.
3.1.3 The Keynesian theory of money (Income-expenditure approach)
Keynes divides the demand for money into three types:
a. The transactions demand, which is the demand by firms and households for holdings of money to
finance day-to-day transactions.
b. Precautionary demand, which arises out of uncertainty and the desire not to be caught short of ready
cash.

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 c. The speculative demand, which is the demand for money as a financial asset and therefore part of a
wealth portfolio.
The transactions demand for money arises because individuals receive their incomes weekly or monthly and
yet have to pay for money of the goods and services they buy on a day-to-day basis. For the economy as a
whole, we can expect the total demand for money for transactions purposes to depend directly on money
nominal income.
Total demand for money
The total demand for money (or total liquidity preference) is found by adding together the transactions,
precautionary and speculative demands.
The liquidity trap
It occurs where the demand for money becomes perfectly interest – elastic at some very lows interest rate.
Thus, if the monetary authorities increased the money supply, the whole of the increase would be added to
speculative balances and the interest rate would remain unchanged. In this extreme case, the velocity of
circulation falls as all increases in the money supply are added to ―idle balances and monetary poling is
powerless to derive down interest rates and, therefore, is unable to give any stimulus to investment or
consumption.
The major weakness of the Keynesian theory of the demand for money is that it is couched in terms of a
choice simply between money and bonds. More recent work has attempted to allow for the fact that holders
of money balances may switch into a whole spectrum of assets, such as equities, trade bills and certificates of
deposits.
3.1.4. The Modern Quantity Theory
Milton Friedman restated the quantity theory of money in 1956 as a theory of the demand for money, and
this theory has become the basis of views put forward by monetarists. In this theory, money is seen as just
one of a number of ways in which wealth can be held, along with all kinds of financial assets, consumer
durables, and property and human wealth. According to Friedman, money has a convenience yield in the
sense that its holding saves time and effect in carrying out transactions.
Friedman sees the real demand for money (MD/P) as depending on total wealth (W), the expected rates of
return on the various forms of assets (rb,re) and expected inflation (Πe)
Portfolio theories predict that the demand for money should depend on the risk and return offered by money
and by the various assets households can hold instead of money. We might write the money demand function
as:
(M/P)d = L(rs, rb, πe , W)
Where rs is the expected real return on stock, rb, is the expected real return on bonds, πe is the expected
inflation rate, and W is real wealth. An increase in rs or rb reduces money demand, because other assets
become more attractive. An increase in πe also reduces money demand, because money becomes less
attractive. An increase in W raises money demand, because higher wealth implies a larger portfolio.
The main problem with this demand for money function is that of finding a method of measuring total
wealth. Friedman suggested that permanent income (YP) may provide an acceptable proxy variable. This is a
long run measure of income.
There are two crucial differences between Keynesian and the Friedman:
1. The Keynesian function includes current national income, whereas Friedman is using permanent
income as a proxy for total wealth.
2. In the Keynesian function (where money is a close substitute for bonds), the demand for money is
interest elastic but in Friedman‗s function (where money is a substitute for all assets, both financial
and real), the demand for money is believed to exhibit low interest, elasticity.
The Baumol-Tobin Model of Cash Management
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The Baumol-Tobin model analyses the costs and benefits of holding money. The benefit of holding money is
convenience; people hold money to avoid making a trip to the bank every time they wish to buy something.
The cost of this convenience is the forgone interest they would have received had they left the money
deposited in a savings account that paid interest.
Consider a person who plans to spend Y birr gradually over the course of year (For simplicity, assume that
the price level is constant, so real spending is constant over the year). There are different possibilities. The
optimal choice of trips (N) is determined by different factors. The greater N is, the less money is held on
average and the less interest is forgone. But as N increases, so does the inconvenience of making frequent
trips to the bank. (Refer N. Gregory Mankiw books and Macroeconomics Modules for detail explanation)
Suppose that the cost of going to the bank is some fixed amount F. F represents the value of the time spent
traveling to and from the bank and waiting in line to make the withdrawal (For example, if a trip to the bank
takes 15 minutes and a person‘s wage is $12 per hour, then F is $3). Also let i denote the interest rate;
because money does not bear interest, i measures the opportunity cost of holding money.
For any N, the average amount of money held is Y/(2N), so the forgone interest is iY/(2N). Because F is the
cost per trip to the bank, the total cost of making trips to the bank is FN.
The total cost the individual bears is the sum of forgone interest and the cost of trips to the banks.
Total cost = Forgone interest + Cost of trips
= iY/(2N) + FN
The larger the number of trips N, the smaller the forgone interest, and the larger the cost of going to the bank.
Figure-6.5 shows how total cost depends on N. There is one value of N that minimizes total cost. The optimal
value of N denoted by N* is:
N* = √
Average money holding = Y/(2N*)
=√
This explanation shows that the individual holds more money if the fixed cost of going to the bank F is
higher, if expenditure Y is higher, or if the interest rate is lower.

3.2 Supply of Money

The quantity of money supply in an economy is defined simply as the value of currencies held by the public
and the deposits at banks that households can use on demand for transactions, such as checking accounts.
That is, letting M denote the money supply, C currency and D demand deposits;
Money supply = Currency + Demand deposits
M=C+D
To understand the money supply, we must understand the interaction between currency and demand deposits.
The deposits that banks have received but have not lent out are called reserves. If all deposits are held as
reserves, such a system is called as ‗100 percent reserve banking‘.
If the public is depositing the entire money in the bank. A birr deposited in a bank reduces currency by one
birr and raises deposits by one birr, so the money supply remains the same.
Now imagine that banks start to use some of their deposits to make loans. The banks must keep some
reserves on hand so that reserves are available whenever depositors want to make withdrawals. This kind of
system is called as ‗fractional reserve banking,‘ a system under which banks keep only a fraction of their
deposits in reserve. (See the detail of money creation from other different macroeconomics modules)
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3.2.1 A Model of the Money Supply
The present model of the money supply is based on fractional-reserve banking. The model has the following
three exogenous variables.
i. Monetary base (B): It is the total number of birr held by the public as currency (C) and by the banks as
reserves (R). It is directly controlled by the National bank.
ii. Reserve-deposit ratio (rr): It is the fraction of deposits that banks hold in reserve. It is determined
by the business policies of banks and the laws regulating banks.
iii. Currency-deposit ratio (cr): It expresses the preferences of the public about how much money to
hold in the form of currency (C) and how much to hold in the form of demand deposits (D).
The present model shows how the money supply depends on the monetary base, the reserve-deposit ratio, and
the currency-deposit ratio. It examines how National bank polices and the choices of banks and households
influence the money supply.
The model begins with the definition of money supply and monetary base.
M = C + D ------------ (1)
B = C + R ------------- (2)
If we divide the first equation by the second, we get:
M/B = C+D/ C+R ------------- (3)
If we divide both the top and bottom of the expression on the right by D:
M/B = C/D + 1 --------------- (4)
C/D+R/D
Note that C/D is the currency-deposit ratio (cr), and that R/D is the reserve-deposit ratio (rr). Making these
substitutions, and bringing the B from the left to the right side of the equation, we obtain:
M = cr + 1 x B ------------- (5)
cr + rr
This equation shows how the money supply depends on the three exogenous variables. Money supply is
proportional to the monetary base. The factor of proportionality [(cr+1)/(cr+rr)] is denoted by m and is called
the ‗money multiplier.‘ That is,
M = m x B -------------- (6)
Each birr of the monetary base produces m birrs of money. Since the monetary base has a multiplier effect on
the money supply, the monetary base is sometimes called ‗high-powered money.‘
The influence of the three exogenous variables (B, rr, and cr) on the money supply can be summarized as
follows.
1. The money supply is proportional to the monetary base. Thus, an increase in the monetary base
increases the money supply by the same percentage.
2. The lower the reserve-deposit ratio, the more loan banks make, and the more money banks create
from every birr of reserves. Thus, a decrease in the reserve-deposit ratio raises the money
multiplier and the money supply.
3. The lower the currency-deposit ratio, the fewer birrs of the monetary base the public holds as
currency, the more base birrs banks hold as reserves, and the more money banks can create.
Thus, a decrease in the currency-deposit ratio raises the money multiplier and the money supply.
With this model in mind, we can discuss the ways in which the national bank influences the money supply.
3.2.2 Instruments of Monetary Policy
The National bank controls the money supply indirectly by altering either the monetary base or the reserve-
deposit ratio.
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 Open market Operations (most frequently used): These are the purchases and sales of government
bonds by the National bank. When the National bank buys bonds from the public, the birr it pays for
the bonds increase the monetary base and thereby increase the money supply. The reverse is true
when the national bank sells bonds to the public.
 Reserve requirements: These are National bank regulations that impose on banks a minimum reserve-
deposit ratio. An increase in reserve requirements raises the reserve-deposit ratio and thus lowers the
money multiplier and the money supply.
 Discount rate: It is the interest rate that the National bank charges when it makes loan to banks.
Banks borrow from the National bank when they find themselves with too few reserves to meet
reserve requirements. The lower the discount rate, the cheaper are borrowed reserves, and the more
banks borrow at the National bank‘s discount window. Hence, reductions in the discount rate raise the
monetary base and the money supply.
Conclusion
Both the Fisher and Cambridge versions of the quantity theory of money state that an increase in the money
supply will lead directly to an increase in spending and with full employment, the general price level will be
proportional to the quantity of money in circulation.
Keynes divided the demand for money into three types: the transactions, precautionary and speculative
demand for money. Transactions demand is the demand by firms and households for money to finance day-
to-day transactions. Precautionary demand arises out of the need to provide for unexpected and unplanned
expenditures. Speculative demand is a demand for money as part of a wealth portfolio.
The transactions and precautionary demands for money are assumed to be positively related to money
national income. The speculative demand for money is assumed to be inversely related to the rate of interest.
In the Keynesian liquidity-preference theory, interaction of the demand for and supply of money determines
the equilibrium rate of interest.
In the modern quantity theory, it is emphasized that money is just one of a number of ways in which wealth
can be held. The real demand for money is assumed to depend on a number of factors, including total wealth
and the expected rates of return on the various forms of wealth.
The central bank does not affect the money supply directly, but in various indirect ways. By engaging in
―open market operations‖ and operating its ―discount window‖. The central bank influence the size of a
monetary base, also known as the supply of high powered money, which is the sum of central bank reserve
notes outside the central bank (held in the vaults of banks or circulatory among the nonbank public) and of
member bank deposits at the central bank.
By setting reserved requirements, the central bank, in turn, helps determine a money multiplier – a number
larger than 1, which indicates how many dollars of money supply, can exist for every $1 of monetary base.
By manipulating the monetary base, the central bank can increase or decrease the money supply through the
process called transmission mechanism, through which changes in the money supply translate themselves
into changes in the nominal GDP

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 CHAPTER FOUR
MODELS OF MACROECONOMIC GROWTH
6.1 INTRODUCTION
Economic growth is the rate of increase in economies‘ potential real output (volume of output) in the
economy over time. It can also be defined as a condition in which a society‘s output of goods and services are
growing faster than the increase in its population.
6.2 Determinants of Economic Growth
There are a number of factors that can determine the growth rate of output of a nation. The main ones are:
A. Human resource and its quality
These are the most important factor in economic growth. It is comprised of the available labour force and the
level of its education, training, and its invention and innovative abilities. It is the main determinant of quality
and quantity of manpower.
B. Natural resources
It includes the area of usable land (particularly arable land), and resources on the land surface and
underground. If a country has modern highly skilled and motivated manpower with rich natural resource, it
will create an amazing situation in the economy.
C. Capital formation
It means scarifying current consumption and saving incomes to be invested. In general the countries with a
high rate of saving and investment have a higher rate of economic growth.
D. Technology (technical progress)
Technology refers to scientific method and techniques of production. Capital – labour ratio is a good measure
of technology. Technological progress or development means improved techniques of production, improved
machinery, invention and improvement of education which improves the quality of capital stock or labour
force. The effect of technological progress in a nation growth path depends on:
i) Whether are rises in the same proportion the productivity of all capital and labour, both new and old?
ii) Whether it raises the productivity of only new labour and capital.
iii) Whether it affects only the productivity of capital
iv) Whether it affect productivity of labour
6.3. Stylized Facts and patterns of growth
Fact 1: There is enormous variation in per capita income across economies. The poorest countries have less
per capita income than advanced countries.
Fact 2: Rates of economic growth vary substantially across countries.
Fact 3: Growth rates are not generally constant over time. Rather it changes over time
Fact 4: A country's relative position in the world distribution of per capita incomes is not immutable.
Countries can move from being "poor" to being "rich", and vice versa.
Difference between economic growth and economic development
 Economic Growth: this implies the rise in the level of output or national income of the country for a
relatively longer period of time. It is a measure of quantity.
 Economic development is not only increase in the level of country‘s GDP or output but it includes
change in quality of education change in the standard of living and technological advancements. In
short it includes both quality and quantity changes.
6.4 Theories of Economic Growth
In this section of the chapter we are going to look at three theoretical models: these are
A) The Harrod and Domar
B) The Solow Growth model( Neo Classical Growth model)
C) Endogenous growth model
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6.4.1 The Harrod – Dommar Model
It is one of the simplest and the earliest growth theories, which extends the simple short run Keynesian model
into the long-run. It is an extension of Keynesian short-term analysis of full employment and income theory
and provides ―a more comprehensive long period theory of output.‖ This model is named after its originators,
the English economist, Sir Roy Harrod and the American, E. Domar.
The central issue of inquiry was to explore the requirements and conditions for steady growth in output and
employment.
Assumptions of H-D model
a. The economy is closed and that there is no government economic activity.
b. There are only two factors of production, labour (L) and capital (K), no technology
c. Labour is homogenous and grows at the constant natural rate of growth.
d. There are constant returns to scale. This means that if a given proportion increases both labours and
capital, output will also increase by that proportion.
e. Saving (s) is a fixed proportion of income (Y) that is S = sY where s is both the average and marginal
propensity of save. Investment is autonomous and there is no depreciation.
f. The potential level of national income (Yp) is proportional to the quantity of capital and labour. It uses a
fixed proportions production function.
Simpler Approach to the H-D model
Investment is a very important variable for the economy because investment has a dual role (it represents an
important component of the demand for the output of an economy as well as the increase in capital stock).
Thus dK = υY. For equilibrium there must be a balance between supply and demand for a nation's output. In
simple case this equilibrium condition reduces to I = S. Thus, the equilibrium growth rate of output is equal
to the ratio of the marginal propensity to save and the Incremental Capital-Output Ratio (ICOR). This is a
very significant result. It tells us how the economy can grow such that the growth in the capacity of the
economy to produce is matched by the demand for the economy's output. (Refer other macroeconomics
modules for numerical examples and detail explanations)
6.4.2The Neo Classical Growth Model (The Basic Solow Model)
The Solow model is built around two equations, a production function and a capital accumulation equation.
The production function describes how inputs are combined to produce output. To simplify the model, we
group these inputs into two categories, capital, K, and labour, L, and denote output as Y. The production
function is assumed to have the Cobb-Douglas form and is given by
Y = F (K, L) = KαL1-α, ----------------------------------------------------- [1]
Where α is some number between 0 and 1. Notice that this production function exhibits constant returns to
scale: if all of the inputs are doubled, outputs will exactly double.
In line with the above-stylized facts, we are interested in explaining output per worker or per capita output.
With this interest in mind, we can rewrite the production function in equation [1] in terms of output per
worker, y ≡ Y/L, and capital per worker, k ≡ K/L - i.e. setting z = 1/L .
Y/L = F (K/L, 1)
y=f (k) where f (k) = F (k, 1)
Equation [1] can, thus, be written as
y = kα------------------------------------------------------------------------------ [2]

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This production function shows with more capital per worker, firms produce more output per worker.
However, there are diminishing returns to capital per worker: each additional unit of capital we give to a
single worker increases the output of that worker by less and less.

y=ka

Figure 6.1 Production function: Solow Model

The second key equation of the Solow model is an equation that describes how capital accumulates. The
capital accumulation equation is given by
.
K  sY  dK -------------------------------------------------------------------- [3]
.
dK
K =
dt
.
According to this equation, the change in the capital stock, K , is equal to the amount of gross investment, sY,
less the amount of depreciation that occurs during the production process, dK. The economy is closed, so that
saving equals investment, and the only use of investment in this economy is to accumulate capital. (Refer
other modules and N.Gregory Mankiw macroeconomics book for detail mathematical derivations)

6.5 The Solow Model: Evaluation

How does the Solow model answer the key questions of growth and development?

 First, the Solow model appeals to differences in investment rates and population growth rates and
(perhaps) to exogenous differences in technology to explain differences in per capita incomes. Why
some countries are so rich and others so poor? According to the Solow model, it is because the rich
countries invest more and has lower population growth rates, both of which allow the rich countries to
accumulate more capital per worker and thus increase labour productivity. This hypothesis is
supported by data across the countries of the world.
 Second, why do economies exhibit sustained growth in the Solow model? The answer is technological
progress. Without technological progress, per capita growth will eventually cease as diminishing
returns to capital set in. Technological progress, however, can offset the tendency for the marginal
product of capital to fall, and in the long run, countries exhibit per capita growth rate of technological
progress.
How, then, does the Solow model account for differences in growth rates across countries?

 At this moment, the Solow model appeals to the transitional dynamics. An economy with a capital-
technology ratio below its long-run level will grow rapidly until the capital-technology ratio reaches
its steady-state level.

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  This reasoning may help explain why some countries such as Japan and Germany, which had their
capital stocks wiped out by World War II, have grown more rapidly than the United States over the
last fifty years.
 Or it may explain why an economy that increases its investment rate will grow rapidly as it makes the
transition to a higher output-technology ratio. This explanation may work well for countries such as
South Korea, Singapore, and Taiwan, which increased their investment rates dramatically since 1950.
6.6 Endogenous Growth Theories

From the Solow growth model we saw that for an economy that exhibits constant returns to scale that simply
accumulating factors of production will not lead to permanently growing values of capital, output, and
consumption per capita. We also saw that while there was some evidence supportive of the Solow growth
model there was also quite a bit of evidence which suggested that quite a bit still needed explaining,
especially why countries kept on growing and what was causing technological change to occur.

For many years this work was left to lie around collecting dust. The oil price shocks, stagflation and other
events all grabbed the attention of most economists away from the work of Solow. Models that try to explain
the source and progress of technological progress often go by the label endogenous growth theory, because
they reject the Solow model‘s assumption of exogenous technological change. Developing such an
understanding is the primary goal of this chapter.

6.6.1 The Simple Endogenous Growth Model: AK model

The basic model

To illustrate the idea behind endogenous growth theory, let‘s start with a particularly simple production
function.
Y = AK……………… eq 1
Where Y is output, K is capital stock, and A is a constant measuring the amount of output produced of each
unit of capital. Notice that this production function does not exhibit the property of diminishing returns to
capital. One extra unit of capital produces an extra unit of output, regardless of how much capital there is.
The absence of diminishing returns to capital is the key difference between this model and the Solow model.
Now let‘s see what this production function says about economic growth. As before, we assume a fraction s
income is saved and invested. We therefore describe capital accumulation with an equation similar to those
we used previously.
K = sY - K…………… eq2
Substituting eq 2in eq 1 gives us
K= s(AK) - K
If we take K as common
K= K(sA-)……………………………………….eq 3
If we divide both side of eq3 by K we will have the growth rate of capital stock

K/K = sA- where s is the saving rate and  is the rate of deprecation
The equation states that the change in the capital stock equals investment (sY) minus depreciation combining
this equation with the Y = AK production function, we obtain after a bit of manipulation.

Y/Y = K/K = sA - 
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This equation shows what determines the growth rate of output. Notice that, as long as A > , the economy
incomes grows forever, even without the assumption of exogenous technological progress.
Thus, a simple change in the production function can alter dramatically the predictions about economic
growth. In the Solow model, saving leads to growth temporarily, but diminishing returns to capital eventually
force the economy to approach a steady state in which growth depends only on exogenous technological
progress. By contrasts in this endogenous growth model, saving and investment can lead to persistent growth.
Advocates of endogenous growth theory, however argue that the assumption of constant (rather than
diminishing) returns to capital is more palatable if growth mode is to view knowledge as a type of capital
clearly, knowledge is an important input into the economy‘s production – both its production of goods and
service and its production of new knowledge compared to their forms of capital, however, it is natural to
assumes that knowledge exhibits the property of diminishing returns. (Indeed, the increasing pace of
scientific and technological innovation over the past few centuries has led some economists to argue that
there are increasing returns to knowledge). If we accept the view that knowledge is a type of capital, then this
endogenous growth model with its assumption of constant returns to capital becomes a more plausible
description of long-run economic growth.
Conclusion
The Solow growth model shows that in the long run, an economy‘s rate of saving determines the size of its
capital stock and thus its level of production. The higher the rate of saving, the higher the stock of capital and
the higher the level of output.

In the Solow model, an increase in the rate of saving causes a period of rapid growth, but eventually that
growth slows as the new steady state is reached. Thus, although a high saving rate yields a high steady-state
level of output, saving by itself cannot generate persistent economic growth.
The Solow model shows that an economy‘s rate of population growth is another long run determines of the
standard of living. The higher the rate of population growth, the lower the level of output per worker.
In the steady state of the Solow growth model, the growth rate of income per person is determined solely by
the exogenous rate of technological progress.

Policy makers in the United States and other countries often claim that their nations should devote a larger
percentage of their output to saving and investment. Increased public saving and tax incentives for private
saving are two ways to encourage capital accumulation.

Many empirical studies have examined to what extent the Solow model can help explain long-run economic
growth. Recent studies have also found that international variation in standards of living is attributed to a
combination of capital accumulation and the efficiency with which capital is used.
Monetary Economics
Chapter One
Money and Monetary Policy
1.1. The Evolution of Money
Increasing the difficulties and inconveniencies of the barter system led to the invention of money. As the
society developed, the division of labor and specialization increased and, as a result, volume of production
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and trade expanded. In such conditions, the barter system of direct exchange between various commodities
created the previously discussed difficulties. In order to overcome these difficulties, money was invented.

Development (Stages in the Evolution) of Money

The origin of money is not known because of the non-availability of recorded information; it is deep-rooted
in antiquity (distant past). Accordingly, the evolution of money has passed through a series of stages
depending up on the progress of human civilization at different times and places.
I. Animal Money: Commodity Money: In many countries, primitive money took the form of commodity
money. A number of commodities like, arrows, animal skins, shells, precious stones, rice, tea, etc.
were used as money. The selection of a commodity to serve as money depends up on different factors
such as location, climate, culture and economic development of the society, etc.
II. Metallic Money: with the spread of civilization and trade relations by land and sea, the composition of
money also changed from animal and commodity money to metallic money. Gold and silver were the
metals mostly used to form metallic money. The use of metals as money ultimately led to the
development of coinage system. But later as the price of gold and silver begun to rise, the coins were
melted in order to earn more by selling as metal than holding them as coins.
III. Paper Money: paper money formed the next stage in the evolution of money. It was introduced in the
17th and 18th Centuries and has now become the most popular form of money. Initially, due to the
safety problem of carrying costlier metals, like gold and silver, from one place to another, the
merchants used to carry paper recipes against metallic money.
IV. Credit Money: along with the paper money, credit money or Bank money also emerged due to the
development of banking institutions and their credit creation activities. Credit money (i.e., cheques
issued against demand deposits), in fact, is not money, it only performs the functions of money. Credit
money is, therefore, regarded as near-money. It is simply a written order to transfer money from one
person to another. A cheque is made for a specific sum, and it expires with a single transaction.

V. Near Money: another stage in the evolution of money has been the use of bills of exchange, treasury
bills, bonds, debentures, saving certificates, etc. these all are known as ―near money‖. They are close
substitutes for money (but not money) and are liquid assets.

VI. Electronic Banking (Payment) Stage: the U.S.A and many other developed countries have now entered
in to an era of electronic banking. Instead of using cash or cheques, people can make deposits and
purchases simply by electronic signals. Does this mean that money is no longer being used or that
money has become obsolete? The answer is certainly no. Electronic banking does not mean the death
of money. It only means that the method of transferring money is changing.
1.2. Classifications of Money
Broadly speaking, three main types of money exist in the modern economy: (a) Metallic Money (b) Paper
Money and (c) Credit Money. Economists however, further classify them in to many other forms. The most
important classifications of money are explained below.
A. Money proper and Money of Account
Money proper or actual money is the money which is in circulation in a country. It is the medium of
exchange and means of payment. In Ethiopia, for example, the Birr note and the Birr Coins are the actual
money because different types of transactions and payments can be made through them.

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Money of account is that in which accounts are maintained (recorded or kept). Prices of goods and services,
general purchasing power, debts, etc are all expressed in terms of money of account. Normally, the money
proper and money of account are the same. In Ethiopia, for example, Birr acts both as a medium of exchange
and the money of account. But, sometimes, the two may be different, particularly at a time of economic
crisis. For example, after World War I, in Germany, the money proper continues to be the German Mark, but
the money of account changed to the American Dollar because of its stable value as compared with the
depreciating Mark.
B. Commodity Money and Representative Money
Money proper or actual money is further divided in to commodity money and representative money.
Commodity money is made of certain metal and its face value is equal to its intrinsic (built-in) value. It
serves not only as a medium of exchange but also as a store of purchasing power. It is also called full-bodied
money because its value is materially equivalent to that of its component stuff.
The money proper in circulation which is not full-bodied is called representative money. It is a type of money
whose value is greater than the value of the stuff of which it is composed (made- of). Paper currency notes
are an example of representative money.
C. Legal Tender and Optional Money
On the basis of acceptability, money has been classified in to legal tender and optional money. Legal tender
money is enforced by law. No one can refuse to accept it as a means of payment. Legal tender money may be
of two types: (a) Limited legal Tender and (b) Unlimited legal tender. Limited legal tender money is accepted
as legal tender only up to a certain limit (ten Birr in coins to pay debts in the Ethiopian case). Unlimited legal
tender is that money which has to be accepted as a medium of payment up to any amount. Example in
Ethiopia currency notes of all denominations are unlimited legal tender.
Optional money is that money which may or may not be accepted as a means of payment; it has no legal
sanction. Different credit instruments, like, cheques, bank drafts, etc, are examples of optional money. No
one can be forced to accept them.
D. Metallic Money
It refers to coins made of certain metals. A coin is a piece of metal of a specific size, shape, weight, and
fineness whose value is certified by the government. Minting of coins is the monopoly of the state. Metallic
money is of two types
(a) Standard Money: any money whose face value is equal to its intrinsic value is called standard or full-
bodied money.
(b) Token Money: the money whose face value is more than its intrinsic value is called token money.
Token coins are generally made of cheaper metals, like, copper, nickel, etc. and mostly represent
lower denominations
E. Paper Money
The money made of paper is called paper money. It consists of currency notes issued by the government or
the central bank (National Bank for the Ethiopian case) of the country. Paper money is of four types:
i. Representative paper money: this money is fully backed by gold and silver reserves. Under the
monetary system of representative money, gold and silver equal to the value of the paper currency
issued are kept in the reserves by the monetary authority. It is also known as representative full bodied
money.

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 ii. Convertible paper money: the paper money which is convertible in to standard coins is called
convertible paper money. However, it is not 100% backed by gold and silver. The only difference
between representative and convertible paper money is that the representative is fully backed by gold
and silver (by standard coins) while the convertible is not fully backed. But both types of money are
convertible.
iii. Inconvertible paper money: the paper money which does not have any backing standard coins (gold
and silver) and is also not convertible in to them is known as inconvertible paper money. Notes issued
by central banks of all countries represent inconvertible paper money. They are also known as
fiduciary money.
iv. Fiat Money: Fiat money is a currency ordered by governments as legal tender (meaning that legally it
must be accepted as payment for debts) but not convertible into coins or precious metal. Fiat money is
not convertible by law and is thus a token money.

F. Credit Money/ Bank Money

Credit money or bank money is transferred by commercial bank in the form of a cheque or draft. But a
cheque or draft is not money. Demand deposit in a bank is money which is withdrawn by a holder of the
deposit through a cheque or draft. But a cheque or draft is not legal tender and may not be accepted as a
means of payment or medium of exchange. However, bank money is as important as paper money/notes.

1.3. What Exactly is Money

As the word money is used in everyday conversation, it can mean many things but to economists it has a very
specific meaning.
Money has been defined different economists. According to Walker, ―Money is that money does‖. Saligman
defines money as ―one thing that possesses general acceptability‖. According to Crowther it is ―anything that
is generally acceptable as a means of exchange and at the same time acts as a measure and store of value‖.
It is clear from the above definitions that the definition of money is essentially functional and also must
satisfy the general acceptability criterion. A complete definition should include all the important functions of
money and also its basic characteristics, that is, general acceptability. Thus, Crowther‘s definition may be
considered better as it covers both these qualities.

Another essential characteristic of money is that it is immediately exchangeable for all other kinds of
marketable assets-goods and services, real estates, stocks and bonds or whatever. In other words, that money
is the most liquid asset (or money has liquidity advantage).

What money is made of, how it looks, etc, makes no difference as long as it performs the functions of money-
and is being used as a generally accepted medium of exchange- it is money.

Thus, a commodity to be accepted as money, it must meet the following criteria.

i. Standardization – it must be easily standardized, making it simple to ascertain its value.
ii. It must be widely accepted
iii. Divisibility – It must be divisible so that it is easy to make a change
iv. Portability – it must be easy to carry
v. Durability – it must not deteriorate quickly

1.4. Basic Functions of Money

In every society, money performs four basic functions. All of these functions play significant roles in the
operation of the economy.

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 1. The Medium of Exchange Function
2. Money as a Unit of Account
3. Money as a Store of Value (Wealth Holding)
4. Money as a Standard of Deferred Payments
1.6. Measuring Money
To measure money, we need a precise definition that tells us exactly what assets should be included. The
Federal Reserve System (the Fed), the central banking authority responsible for monetary policy in the
United States for example, has conducted many studies on how to measure money.
Since 1980, the Fed has modified its measures of money several times and has settled on the following
measures of the money supply, which are also referred to as monetary aggregates (see Table 1 and the
Following the Financial News box).
Components of money (measures of Money)

CHAPTER TWO
2. AN OVERVIEW OF FINANCIAL SYSTEM

2.1. Function and Structures of Financial Markets

Financial markets perform the essential economic function of channeling funds from households, firms, and
governments that have saved surplus funds by spending less than their income to those that have a shortage of
funds because they wish to spend more than their income. This function is shown schematically in Figure 1.
Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow
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funds to finance their spending, the borrower-spenders, are at the right. The principal lender-savers are
households, but business enterprises and the government (particularly state and local government), as well as
foreigners and their governments, sometimes also find themselves with excess funds and so lend them out.

The most important borrower-spenders are businesses and the government (particularly the federal
government), but households and foreigners also borrow to finance their purchases of cars, furniture, and
houses. The arrows show that funds flow from lender-savers to borrower-spenders via two routes.

In direct finance (the route at the bottom of Figure 1), borrowers borrow funds directly from lenders in
financial markets by selling them securities (also called financial instruments), which are claims on the
borrower‘s future income or assets. Securities are assets for the person who buys them but liabilities (IOUs
or debts) for the individual or firm that sells (issues) them. For example, if General Motors needs to borrow
funds to pay for a new factory to manufacture electric cars, it might borrow the funds from savers by selling
them bonds, debt securities that promise to make payments periodically for a specified period of time.

Why is this channeling of funds from savers to spenders so important to the economy? The answer is that the
people who save are frequently not the same people who have profitable investment opportunities available
to them, the entrepreneurs. Let‘s first think about this on a personal level. Without financial markets, it is
hard to transfer funds from a person who has no investment opportunities to one who has them; you would
both be stuck with the status quo, and both of you would be worse off. Financial markets are thus essential to
promoting economic efficiency.
Financial markets have an important function in the economy; they allow funds to move from people who
lack productive investment opportunities to people who have such opportunities. Thus financial markets are
critical for producing an efficient allocation of capital, which contributes to higher production and efficiency
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for the overall economy. Indeed, when financial markets break down during financial crises, as they have in
Mexico, East Asia, and Argentina in recent years, severe economic hardship results, which can even lead to
dangerous political instability.
Well-functioning financial markets also directly improve the well-being of consumers by allowing them to
time their purchases better. They provide funds to young people to buy what they need and can eventually
afford without forcing them to wait until they have saved up the entire purchase price. Financial markets that
are operating efficiently improve the economic welfare of everyone in the society.

Structure of Financial Markets

Debt and Equity Markets
Now that we understand the basic function of financial markets, let‘s look at their structure. The following
descriptions of several categorizations of financial markets illustrate essential features of these markets. A
firm or an individual can obtain funds in a financial market in two ways. The most common method is to
issue a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to
pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments)
until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is
the number of years (term) until that instrument‘s expiration date. A debt instrument is short-term if its
maturity is less than a year and long-term if its maturity is ten years or longer. Debt instruments with a
maturity between one and ten years are said to be intermediate-term. The second method of raising funds is
by issuing equities, such as common stock, which are claims to share in the net income (income after
expenses and taxes) and the assets of a business. If you own one share of common stock in a company that
has issued one million shares, you are entitled to 1 one-millionth of the firm‘s net income and 1 one-millionth
of the firm‘s assets. Equities often make periodic payments (dividends) to their holders and are considered
long-term securities because they have no maturity date. In addition, owning stock means that you own a
portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors.

The main disadvantage of owning a corporation‘s equities rather than its debt is that an equity holder is a
residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders. The
advantage of holding equities is that equity holders benefit directly from any increases in the corporation‘s
profitability or asset value because equities confer ownership rights on the equity holders. Debt holders do
not share in this benefit, because their dollar payments are fixed.

Primary and Secondary Markets

A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold
to initial buyers by the corporation or government agency borrowing the funds. A secondary market is a
financial market in which securities that have been previously issued (and are thus secondhand) can be
resold. The primary markets for securities are not well known to the public because the selling of securities to
initial buyers often takes place behind closed doors. An important financial institution that assists in the
initial sale of securities in the primary market is the investment bank. It does this by underwriting
securities: It guarantees a price for a corporation‘s securities and then sells them to the public. The New York
and American stock exchanges and NASDAQ, in which previously issued stocks are traded, are the best-
known examples of secondary markets, although the bond markets, in which previously issued bonds of
major corporations and the U.S. government are bought and sold, actually have a larger trading volume.
Another example of secondary markets is foreign exchange markets.

Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of
investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling

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securities at stated prices. When an individual buys a security in the secondary market, the person who has
sold the security receives money in exchange for the security, but the corporation that issued the security
acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary
market. Nonetheless, secondary markets serve two important functions.
 First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make
the financial instruments more liquid.
 Second, they determine the price of the security that the issuing firm sells in the primary market.

Exchanges and Over-the-Counter Markets

Secondary markets can be organized in two ways. One is to organize exchanges, where buyers and sellers of
securities (or their agents or brokers) meet in one central location to conduct trades. The New York and
American stock exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver,
and other raw materials) are examples of organized exchanges. The other method of organizing a secondary
market is to have an over-the counter (OTC) market, in which dealers at different locations who have an
inventory of securities stand ready to buy and sell securities ―over the counter‖ to anyone who comes to them
and is willing to accept their prices. Because over-the-counter dealers are in computer contact and know the
prices set by one another, the OTC market is very competitive and not very different from a market with an
organized exchange.

Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity of the securities traded in each
market. The money market is a financial market in which only short-term debt instruments (generally those
with original maturity of less than one year) are traded; the capital market is the market in which longer-
term debt (generally those with original maturity of one year or greater) and equity instruments are traded.
Money market securities are usually more widely traded than longer-term securities and so tend to be more
liquid. In addition, short-term securities have smaller fluctuations in prices than long-term securities, making
them safer investments. As a result, corporations and banks actively use the money market to earn interest on
surplus funds that they expect to have only temporarily. Capital market securities, such as stocks and long-
term bonds, are often held by financial intermediaries such as insurance companies and pension funds, which
have little uncertainty about the amount of funds they will have available in the future.

Function of Financial Intermediaries

As shown in Figure 1, funds can move from lenders to borrowers by a second route, called indirect finance
because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders
and helps transfer funds from one to the other. A financial intermediary does this by borrowing funds from
the lender savers and then using these funds to make loans to borrower-spenders. For example, a bank might
acquire funds by issuing a liability to the public (an asset for the public) in the form of savings deposits. It
might then use the funds to acquire an asset by making a loan to General Motors or by buying a GM bond in
the financial market. The ultimate result is that funds have been transferred from the public (the lender-
savers) to GM (the borrower-spender) with the help of the financial intermediary (the bank).
The process of indirect finance using financial intermediaries, called financial intermediation, is the
primary route for moving funds from lenders to borrowers. Indeed, although the media focus much of their
attention on securities markets, particularly the stock market, financial intermediaries are a far more
important source of financing for corporations than securities markets are.

2.2. Financial Market Instruments

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Here we examine the securities (instruments) traded in financial markets. We first focus on the instruments
traded in the money market and then turn to those traded in the capital market.

Money Market Instruments

Because of their short terms to maturity, the debt instruments traded in the money market undergo the least
price fluctuations and so are the least risky investments. The money market has undergone great changes in
the past three decades, with the amount of some financial instruments growing at a far more rapid rate than
others.

Treasury Bills: These short-term debt instruments of the governments are issued in 3-, 6-, and 12-month
maturities to finance the federal government.

Negotiable Bank Certificates of Deposit: A certificate of deposit (CD) is a debt instrument, sold by a bank
to depositors, that pays annual interest of a given amount and at maturity, pays back the original purchase
price.

Commercial Paper: Commercial paper is a short-term debt instrument issued by large banks and well-
known corporations, such as General Motors.

Banker’s Acceptances: These money market instruments are created in the course of carrying out
international trade and have been in use for hundreds of years. A banker’s acceptance is a bank draft (a
promise of payment similar to a check) issued by a firm, payable at some future date, and guaranteed for a fee
by the bank that stamps it ―accepted.‖

Repurchase Agreements: Repurchase agreements, or repos, are effectively short-term loans (usually with a
maturity of less than two weeks) in which Treasury bills serve as collateral, an asset that the lender receives
if the borrower does not pay back the loan

Federal (Fed) Funds: These are typically overnight loans between banks of their deposits at the Federal
Reserve.
Capital Market Instruments
Capital market instruments are debt and equity instruments with maturities of greater than one year. They
have far wider price fluctuations than money market instruments and are considered to be fairly risky
investments.

Stocks: Stocks are equity claims on the net income and assets of a corporation. The amount of new stock
issues in any given year is typically quite small-less than 1% of the total value of shares outstanding.
Individuals hold around half of the value of stocks; the rest are held by pension funds, mutual funds, and
insurance companies.

Mortgages: Mortgages are loans to households or firms to purchase housing, land, or other real structures,
where the structure or land itself serves as collateral for the loans. The mortgage market is the largest debt
market in the United States. Savings and loan associations and mutual savings banks have been the primary
lenders in the residential mortgage market, although commercial banks have started to enter this market more
aggressively. The majority of commercial and farm mortgages are made by commercial banks and life
insurance companies.

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Corporate Bonds: These are long-term bonds issued by corporations with very strong credit ratings. The
typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the
bond matures. Some corporate bonds, called convertible bonds, have the additional feature of allowing the
holder to convert them into a specified number of shares of stock at any time up to the maturity date.

Government Securities: These long-term debt instruments are issued by the government Treasury to finance
the deficits of the federal government. Because they are the most widely traded bonds, they are the most
liquid security traded in the capital market. They are held by the Federal Reserve, banks, households, and
foreigners.

Government Agency Securities: These are long-term bonds issued by various government agencies to
finance such items as mortgages, farm loans, or power generating equipment. Many of these securities are
guaranteed by the federal government. They function much like government bonds and are held by similar
parties.

State and Local Government Bonds: State and local bonds, also called municipal bonds, are long-term debt
instruments issued by state and local governments to finance expenditures on schools, roads, and other large
programs.

Consumer and Bank Commercial Loans: These are loans to consumers and businesses made principally by
banks, but-in the case of consumer loans-also by finance companies. There are often no secondary markets in
these loans, which makes them the least liquid of the capital market instruments. However, secondary
markets have been rapidly developing.

CHAPTER THREE
THE DEMAND FOR MONEY
3.1. Definition
Having discussed the functions of money and the definition of the money, we now examine the factors that
determine the amount of money an individual desires to hold. The demand for money refers to the amount of
money an individual desires to hold as cash or current account deposits. The determinants of individual
money demand can be derived from the theory of asset demand.
3.2. Quantity Theory of Money
This theory is developed by classical economists in the nineteenth and early twentieth century; the quantity
theory of money is a theory of how the nominal value of aggregate income is determined. Because it also tells
us how much money is held for a given amount of aggregate income, it is also a theory of the demand for
money. The most important feature of this theory is that it suggests that interest rates have no effect on the
demand for money.

V= …………………….. (1)

By multiplying both sides of this definition by M, we obtain the equation of exchange, which relates
nominal income to the quantity of money and velocity:

M X V = P X Y ………………….. (2)

We can see this by dividing both sides of the equation of exchange by V, thus rewriting it as:
M=
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Using k to represent the quantity 1/V (a constant, because V is a constant), we can rewrite the equation as:
Md = k X PY…………. (3)
Equation 3 tells us that because k is a constant, the level of transactions generated by a fixed level of nominal
income PY determines the quantity of money demanded, Md by people. Therefore, Fisher‘s quantity theory of
money suggests that the demand for money is purely a function of income, and interest rates have no effect
on the demand for money. Fisher came to this conclusion because he believed that people hold money only to
conduct transactions and have no freedom of action in terms of the amount they want to hold. The demand
for money is determined (1) by the level of transactions generated by the level of nominal income PY and (2)
by the institutions in the economy that affect the way people conduct transactions and thus determine velocity
and hence k.

3.3. Keynes’s Liquidity Preference Theory

In his famous 1936 book The General Theory of Employment, Interest, and Money, John Maynard Keynes
abandoned the classical view that velocity was a constant and developed a theory of money demand that
emphasized the importance of interest rates. His theory of the demand for money, which he called the
liquidity preference theory, asked the question: Why do individuals hold money? He postulated that there
are three motives behind the demand for money: the transactions motive, the precautionary motive, and the
speculative motive.

Putting the Three Motives Together

In putting the three motives for holding money balances together into a demand for money equation, Keynes
was careful to distinguish between nominal quantities and real quantities. Money is valued in terms of what it
can buy. If for example, all prices in the economy double (the price level doubles), the same nominal quantity
of money will be able to buy only half as many goods. Keynes thus reasoned that people want to hold a
certain amount of real money balances (the quantity of money in real terms)—an amount that his three
motives indicated would be related to real income Y and to interest rates i. Keynes wrote down the following
demand for money equation, known as the liquidity preference function, which says that the demand for real
money balances Md/P is a function of i and Y:
=f( )…………………….. (4)

Multiplying both sides of this equation by Y and recognizing that Md can be replaced by M because they
must be equal in money market equilibrium, we solve for velocity
( )
= V…………………... (5)
To sum up, Keynes‘s liquidity preference theory postulated three motives for holding money: the transactions
motive, the precautionary motive, and the speculative motive. Although Keynes took the transactions and
precautionary components of the demand for money to be proportional to income, he reasoned that the
speculative motive would be negatively related to the level of interest rates.

Keynes‘s model of the demand for money has the important implication that velocity is not constant, but
instead is positively related to interest rates, which fluctuate substantially. His theory also rejected the
constancy of velocity, because changes in people‘s expectations about the normal level of interest rates would
cause shifts in the demand for money that would cause velocity to shift as well. Thus Keynes‘s liquidity
preference theory casts doubt on the classical quantity theory that nominal income is determined primarily by
movements in the quantity of money.

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3.3. Friedman’s Modern Quantity Theory of Money
In 1956, Milton Friedman developed a theory of the demand for money in a famous article, ―The Quantity
Theory of Money: A Restatement.‖ Although Friedman frequently refers to Irving Fisher and the quantity
theory, his analysis of the demand for money is actually closer to that of Keynes than it is to Fisher‘s. Like
his predecessors, Friedman pursued the question of why people choose to hold money. Instead of analyzing
the specific motives for holding money, as Keynes did, Friedman simply stated that the demand for money
must be influenced by the same factors that influence the demand for any asset. Friedman then applied the
theory of asset demand to money.
The theory of asset demand indicates that the demand for money should be a function of the resources
available to individuals (their wealth) and the expected returns on other assets relative to the expected return
on money. Like Keynes, Friedman recognized that people want to hold a certain amount of real money
balances (the quantity of money in real terms). From this reasoning, Friedman expressed his formulation of
the demand for money as follows:
=f( )……………….. (6)
+, - , - , -
Where: = Demand for real money balance
= Friedman‘s measure of wealth, known as permanent income (technically, the present discounted
value of all expected future income, but more easily described as expected average long run income)
= Expected return on bond
= Expected return on money
= Expected return on equity (common stock)
= Expected inflation rate

and the signs underneath the equation indicate whether the demand for money is positively (+) related or
negatively (-) related to the terms that are immediately above them.

Distinguishing Between the Friedman and Keynesian Theories

There are several differences between Friedman‘s theory of the demand for money and the Keynesian
theories. One is that by including many assets as alternatives to money, Friedman recognized that more than
one interest rate is important to the operation of the aggregate economy. Keynes, for his part, lumped
financial assets other than money into one big category-bonds-because he felt that their returns generally
move together.

Unlike Keynes’s theory, which indicates that interest rates are an important determinant of the demand for
money, Friedman’s theory suggests that changes in interest rates should have little effect on the demand
for money.

Therefore, Friedman‘s money demand function is essentially one in which permanent income is the primary
determinant of money demand, and his money demand equation can be approximated by:

= f ( ) …………………………… (7)
In Friedman‘s view, the demand for money is insensitive to interest rates-not because he viewed the demand
for money as insensitive to changes in the incentives for holding other assets relative to money, but rather
because changes in interest rates should have little effect on these incentive terms in the money demand

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function. The incentive terms remain relatively constant, because any rise in the expected returns on other
assets as a result of the rise in interest rates would be matched by a rise in the expected return on money.
The second issue Friedman stressed is the stability of the demand for money function. In contrast to Keynes,
Friedman suggested that random fluctuations in the demand for money are small and that the demand for
money can be predicted accurately by the money demand function. When combined with his view that the
demand for money is insensitive to changes in interest rates, this means that velocity is highly predictable.
We can see this by writing down the velocity that is implied by the money demand equation (Equation 7).
V= …………………… (8)
( )
Because the relationship between Y and YP is usually quite predictable, a stable money demand function (one
that does not undergo pronounced shifts, so that it predicts the demand for money accurately) implies that
velocity is predictable as well. If we can predict what velocity will be in the next period, a change in the
quantity of money will produce a predictable change in aggregate spending. Even though velocity is no
longer assumed to be constant, the money supply continues to be the primary determinant of nominal income
as in the quantity theory of money. Therefore, Friedman‘s theory of money demand is indeed a restatement of
the quantity theory, because it leads to the same conclusion about the importance of money to aggregate
spending. You may recall that we said that the Keynesian liquidity preference function (in which interest
rates are an important determinant of the demand for money) is able to explain the pro-cyclical movements of
velocity that we find. Can Friedman‘s money demand formulation explain this pro-cyclical velocity
phenomenon as well?
The key clue to answering this question is the presence of permanent income rather than measured income in
the money demand function. What happens to permanent income in a business cycle expansion? Because
much of the increase in income will be transitory, permanent income rises much less than income.
Friedman‘s money demand function then indicates that the demand for money raises only a small amount
relative to the rise in measured income, and as Equation 8 indicates, velocity rises. Similarly, in a recession,
the demand for money falls less than income, because the decline in permanent income is small relative to
income, and velocity falls. In this way, we have the pro-cyclical movement in velocity.

To summarize, Friedman‘s theory of the demand for money used a similar approach to that of Keynes but did
not go into detail about the motives for holding money. Instead, Friedman made use of the theory of asset
demand to indicate that the demand for money will be a function of permanent income and the expected
returns on alternative assets relative to the expected return on money. There are two major differences
between Friedman’s theory and Keynes’s. Friedman believed that changes in interest rates have little effect
on the expected returns on other assets relative to money. Thus, in contrast to Keynes, he viewed the demand
for money as insensitive to interest rates. In addition, he differed from Keynes in stressing that the money
demand function does not undergo substantial shifts and is therefore stable. These two differences also
indicate that velocity is predictable; yielding a quantity theory conclusion that money is the primary
determinant of aggregate spending.

3.4. Empirical Evidence on the Demand for Money

As we have seen, the alternative theories of the demand for money can have very different implications for
our view of the role of money in the economy. Which of these theories is an accurate description of the real
world is an important question, and it is the reason why evidence on the demand for money has been at the
center of many debates on the effects of monetary policy on aggregate economic activity. Here we examine
the empirical evidence on the two primary issues that distinguish the different theories of money demand and
affect their conclusions about whether the quantity of money is the primary determinant of aggregate
spending: Is the demand for money sensitive to changes in interest rates, and is the demand for money
function stable over time?
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Interest Rates and Money Demand
Earlier in the chapter, we saw that if interest rates do not affect the demand for money, velocity is more likely
to be a constant—or at least predictable—so that the quantity theory view that aggregate spending is
determined by the quantity of money is more likely to be true. However, the more sensitive the demand for
money is to interest rates, the more unpredictable velocity will be, and the less clear the link between the
money supply and aggregate spending will be. Indeed, there is an extreme case of ultra-sensitivity (very
sensitive) of the demand for money to interest rates, called the liquidity trap, in which monetary policy has no
effect on aggregate spending, because a change in the money supply has no effect on interest rates. (If the
demand for money is ultrasensitive to interest rates, a tiny change in interest rates produces a very large
change in the quantity of money demanded. Hence in this case, the demand for money is completely flat in
the supply and demand diagrams. Therefore, a change in the money supply that shifts the money supply
curve to the right or left results in it intersecting the flat money demand curve at the same unchanged interest
rate.) The evidence on the interest sensitivity of the demand for money found by different researchers is
remarkably consistent. Neither extreme case is supported by the data: The demand for money is sensitive to
interest rates, but there is little evidence that a liquidity trap has ever existed.

Stability of Money Demand

If the money demand function, like Equation 4 or 6, is unstable and undergoes substantial unpredictable
shifts, as Keynes thought, then velocity is unpredictable, and the quantity of money may not be tightly linked
to aggregate spending, as it is in the modern quantity theory. The stability of the money demand function is
also crucial to whether the Federal Reserve should target interest rates or the money supply. Thus it is
important to look at the question of whether the money demand function is stable, because it has important
implications for how monetary policy should be conducted. By the early 1970s, evidence strongly supported
the stability of the money demand function. However, after 1973, the rapid pace of financial innovation,
which changed what items, could be counted as money, led to substantial instability in estimated money
demand functions. The recent instability of the money demand function calls into question whether our
theories and empirical analyses are adequate. It also has important implications for the way monetary policy
should be conducted, because it casts doubt on the usefulness of the money demand function as a tool to
provide guidance to policymakers. In particular, because the money demand function has become unstable,
velocity is now harder to predict, and setting rigid money supply targets in order to control aggregate
spending in the economy may not be an effective way to conduct monetary policy.
CHAPTER FOUR
4. THE MONEY SUPPLY PROCESS
4.1. Players in the Money Supply Process
The ―cast of characters/actors‖ in the money supply story is as follows:
1. The central bank—the government agency that oversees the banking system and is responsible for the
conduct of monetary policy; in Ethiopia, it is called the National Bank
2. Banks (depository institutions)—the financial intermediaries that accept deposits from individuals and
institutions and make loans: commercial banks, savings and loan associations, mutual savings banks,
and credit unions
3. Depositors—individuals and institutions that hold deposits in banks
4. Borrowers from banks—individuals and institutions that borrow from the depository institutions and
institutions that issue bonds that are purchased by the depository institutions
Of the four players, the central bank-the National Bank-is the most important.
4.2. Determinants of the Money Supply
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The main determinants of money supply are (a) the monetary base and (b) the money multiplier. These two
broad determinants of money supply are, in turn, influenced by a number of factors. The various factors
influencing the money supply are discussed below:

1. Reserve ratio- reserve ratio (r) is also an important determinant of money supply. The smaller cash
reserve ratio enables greater credit expansion in the banks and thus increases the money supply and vice
versa. Reserve ratio is often broken down in to its component parts; (a) excess reserve ratio which is the
ratio of excess reserves to the total deposits of the bank (e= ER/D); (b) required reserve ratio which is the
ratio of the required reserves to the total deposits of the bank (r = RR/D). Thus, R = e + r. The required
reserve ratio, r is legally fixed by the central bank and the excess reserve ratio depends on the market rate
of interest.
2. Currency ratio- currency ratio (c) is a behavioral ratio representing the ratio of currency demand to the
demand deposits. The effect of the currency ratio on the money multiplier (m) can not be clearly
recognized because currency ratio, c enters both as a numerator and a denominator in the money
multiplier expression (1+c/r + e + c). But, as long as the reserve ratio, r is less than unity, a rise in the
currency ratio must reduce the multiplier.
3. Monetary base- magnitude of the monetary base (MB) is the significant determinant of the size of money
supply. Money supply varies directly in relation to the changes in the monetary base. Monetary base
refers to the supply of funds available for use either as cash or reserves in the central bank. Monetary base
changes due to the policy of the government and is also influenced by the value of money.
4. Money multiplier- Money multiplier (m) has positive influence up on the money supply. An increase in
the size of m will increase the money supply.
4.3. Control of the Monetary Base
The monetary base (also called high-powered money) equals currency in circulation C plus the total
reserves in banking system R. The monetary base MB can be expressed as
MB = C + R
The Federal Reserve exercises control over the monetary base through its purchases or sale of government
securities in the open market, called open market operations, and through its extension of discount loans to
banks. The primary way in which the Fed causes changes in the monetary base is through its open market
operations. A purchase of bonds by the Fed is called an open market purchase, and a sale of bonds by the
Fed is called an open market sale.
4.4. The Money Supply Model and the Money Multiplier
Money supply is generally considered as a policy-determined phenomenon. But this view is not true. The
modern theory of money supply maintains that the money supply is jointly determined by the central bank,
the commercial banks and the public. Money supply (M) is the product of monetary base (MB) and money
multiplier (m). Thus,
M = m x MB………………. (1)
The variable m is the money multiplier, which tells us how much the money supply changes for a given
change in the monetary base MB. This multiplier tells us what multiple of the monetary base is transformed
into the money supply. Because the money multiplier is larger than 1, the alternative name for the monetary
base, high powered money, is logical; a $1 change in the monetary base leads to more than a $1 change in the
money supply.
The money multiplier reflects the effect on the money supply of other factors besides the monetary base, and
the following model will explain the factors that determine the size of the money multiplier. Depositors‘
decisions about their holdings of currency and checkable deposits are one set of factors affecting the money
multiplier. Another involves the reserve requirements imposed by the Fed on the banking system. Banks‘
decisions about excess reserves also affect the money multiplier.
Deriving the Money Multiplier
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The desired level of currency C and excess reserves ER grows proportionally with checkable deposits D; in
other words, we assume that the ratios of these items to checkable deposits are constants in equilibrium, as
the braces in the following expressions indicate:
c = {C/D} _ currency ratio
e = {ER/D} _ excess reserves ratio
We will now derive a formula that describes how the currency ratio desired by depositors, the excess reserves
ratio desired by banks, and the required reserve ratio set by the Fed affect the multiplier m. We begin the
derivation of the model of the money supply with the equation:
R = RR + ER

which states that the total amount of reserves in the banking system R equals the sum of required reserves RR
and excess reserves ER. (Note that this equation corresponds to the equilibrium condition RR, where excess
reserves were assumed to be zero).The total amount of required reserves equals the required reserve ratio r
times the amount of checkable deposits D:
RR = r x D
Substituting r x D for RR in the first equation yields an equation that links reserves in the banking system to
the amount of checkable deposits and excess reserves they can support:
R = (r x D) + ER
Because the monetary base MB equals currency C plus reserves R, we can generate an equation that links the
amount of monetary base to the levels of checkable deposits and currency by adding currency to both sides of
the equation:
MB = R + C = (r x D) + ER + C
Another way of thinking about this equation is to recognize that it reveals the amount of the monetary base
needed to support the existing amounts of checkable deposits, currency, and excess reserves.
An important feature of this equation is that an additional dollar of MB that arises from an additional dollar of
currency does not support any additional deposits. This occurs because such an increase leads to an identical
increase in the right-hand side of the equation with no change occurring in D. The currency component of
MB does not lead to multiple deposit creation as the reserves component does. Put another way, an increase
in the monetary base that goes into currency is not multiplied, whereas an increase that goes into supporting
deposits is multiplied.

Another important feature of this equation is that an additional dollar of MB that goes into excess reserves ER
does not support any additional deposits or currency. The reason for this is that when a bank decides to hold
excess reserves, it does not make additional loans, so these excess reserves do not lead to the creation of
deposits.

Therefore, if the Fed injects reserves into the banking system and they are held as excess reserves, there will
be no effect on deposits or currency and hence no effect on the money supply. In other words, you can think
of excess reserves as an idle component of reserves that are not being used to support any deposits (although
they are important for bank liquidity management). This means that for a given level of reserves, a higher
amount of excess reserves implies that the banking system in effect has fewer reserves to support deposits.
To derive the money multiplier formula in terms of the currency ratio c = {C/D} and the excess reserves ratio
e = {ER/D}, we rewrite the last equation, specifying C as
c x D and ER as e x D:
MB = (r x D) + (e x D) + (c x D) = (r + e +c) x D
We next divide both sides of the equation by the term inside the parentheses to get an expression linking
checkable deposits D to the monetary base MB:

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 D= 𝑀 …………………….. (2)
Using the definition of the money supply as currency plus checkable deposits (M =
D + C) and again specifying C as c x D,
M = D + (c x D) = (1 + c) x D
Substituting in this equation the expression for D from Equation 2, we have:
M= 𝑀 …………………….. (3)
Finally, we have achieved our objective of deriving an expression in the form of our earlier Equation 1. As
you can see, the ratio that multiplies MB is the money multiplier that tells how much the money supply
changes in response to a given change in the monetary base (high-powered money). The money multiplier m
is thus:

m= …………………….. (4)
and it is a function of the currency ratio set by depositors c, the excess reserves ratio set by banks e, and the
required reserve ratio set by the Fed r.
Although the algebraic derivation we have just completed shows you how the money multiplier is
constructed, you need to understand the basic intuition behind it to understand and apply the money
multiplier concept without having to memorize it.
4.5. Factors That Determine the Money Multiplier
To develop our intuition of the money multiplier even further, let us look at how this multiplier changes in
response to changes in the variables in our model: c, e, and r. The ―game‖ we are playing is a familiar one in
economics: We ask what happens when one of these variables changes, leaving all other variables the same
(ceteris paribus).
Changes in the Required Reserve Ratio r: The money multiplier and the money supply are negatively
related to the required reserve ratio r.
Changes in the Currency Ratio c: The money multiplier and the money supply are negatively related to the
currency ratio c.
Changes in the Excess Reserves Ratio e: The money multiplier and the money supply are negatively related
to the excess reserves ratio e.
Market Interest Rates: The banking system’s excess reserves ratio e is negatively related to the market
interest rate i.
Expected Deposit Outflows: The excess reserves ratio e is positively related to expected deposit outflows.

CHAPTER FIVE
Central Banking and Monetary Policy

5.1 Central banking and the conduct of monetary policy

5.1.1 Central Banking

Central banks are relatively new inventions. An American President (Andrew Jackson) even
cancelled his country's central bank in the nineteenth century because he did not think that it
was very important. But things have changed since. Central banks today are the most
important feature of the financial systems of most countries of the world.
Central banks are bizarre hybrids. Some of their functions are identical to the functions of
regular, commercial banks. Other functions are unique to the central bank. On certain
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 functions it has an absolute legal monopoly.
A nation's principal monetary authority, such as the Federal Reserve Bank (USA) and National
Bank of Ethiopia, which regulates the money supply and credit, issues currency, and manages
the rate of exchange.
It is the entity responsible for overseeing the monetary system for a nation (or group of
nations). Central banks have a wide range of responsibilities - from overseeing monetary
policy to implementing specific goals such as currency stability, low inflation and full
employment. Central banks also generally issue currency, function as the bank of the
government, regulate the credit system, oversee commercial banks, manage exchange reserves
and act as a lender of last resort.
I. Activities and responsibilities of Central Banks
Functions of a central bank (not all functions carried out by all banks):
 Monopoly on the issue of banknotes
 The government's banker
 The bankers' bank ("lender of last resort")
 Manages the country's foreign exchange and gold reserves and the government's stock
register;
 Regulation and supervision of the banking industry:
 Setting the official interest rate - used to manage both inflation and the country's exchange rate
and ensuring that this rate takes effect via a variety of policy mechanisms
II. Policy instruments of the Central Bank
Monetary policy instruments may be divided in to two main types.
I. Direct controls
Direct controls are typically directives given by the central bank to control the quantity or
price (interest rate) of money deposited with commercial banks and credit provided by them.
Ceilings on the growth of bank lending or deposits are examples of quantity controls.
Maximum bank lending or deposit rates are examples of interest rate controls.
II. Indirect instruments
An important reason for financial liberalization is to develop a system which promotes an
efficient allocation of savings and credit in the economy. In the monetary area, financial
liberalization involves a movement away from direct monetary controls towards indirect ones.
The latter operate by the central bank controlling the price or volume of the supply of its own
liabilities - reserve money - which in turn may affect interest rates more widely and the
quantity of money and credit in the whole banking system.

Indirect instruments used in monetary operations are often divided in to three:

1. Open Market Operations (OMO)
2. Reserve Requirements
3. Discount Policy

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 III. Central bank independence
 Why is central bank independence an important issue?
 What is central bank independence?
5.2. Conduct of monetary policy: goals and targets
Now that we understand the tools central banks like the Federal Reserve (USA) and National
Bank (Ethiopia) use to conduct monetary policy, we can proceed to see how monetary policy
is actually conducted by central banks. Understanding the conduct of monetary policy is
important because it not only affects the money supply and interest rates but also has a major
influence on the level of economic activity and hence on our wellbeing.

To explore this subject, we look at the goals that the central banks establish for monetary
policy and their strategies for attaining them.
Goals of monetary policy
Six basic goals are continually mentioned by personnel at the Federal Reserve and other
central banks when they discuss the objectives of monetary policy: (1) high employment, (2)
economic growth, (3) price stability, (4) interest-rate stability, (5) stability of financial
markets, and (6) stability in foreign exchange markets.
Conflict among Goals
Although many of the goals mentioned are consistent with each other-high employment with
economic growth, interest-rate stability with financial market stability-this is not always the
case. The goal of price stability often conflicts with the goals of interest-rate stability and high
employment in the short run (but probably not in the long run). For example, when the
economy is expanding and unemployment is falling, both inflation and interest rates may start
to rise. If the central bank tries to prevent a rise in interest rates, this may cause the economy
to overheat and stimulate inflation. But if a central bank raises interest rates to prevent
inflation, in the short run unemployment may rise. The conflict among goals may thus present
central banks with some hard choices.

Central bank strategy: use of targets

The central bank's problem is that it wishes to achieve certain goals, such as price stability
with high employment, but it does not directly influence the goals. It has a set of tools to
employ (open market operations, changes in the discount rate, and changes in reserve
requirements) that can affect the goals indirectly after a period of time (typically more than a
year). If the central bank waits to see what the price level and employment will be one year
later, it will be too late to make any corrections to its policy-mistakes will be irreversible.

All central banks consequently pursue a different strategy for conducting monetary policy by
aiming at variable that lie between its tools and the achievement of its goals. The strategy is as
follows: After deciding on its goals for employment and the price level, the central bank
chooses a set of variables to aim for, called intermediate targets, such as the monetary
aggregates (M1,M2, or M3) or interest rates (short- or long-term), which have direct effect on
employment and the price level. However, even these intermediate targets are not directly
affected by the central bank's policy tools.
Therefore, it chooses another set of variables to aim for, called operating targets, or
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 alternatively called instruments, such as reserve aggregates (reserves, non-borrowed reserves,
monetary base, or non-borrowed base) or interest rates (federal funds rate or Treasury bill
rate), which are more responsive to its policy tools. (Recall that non-borrowed reserves are
total, reserves minus borrowed reserves; which are the amount of discount loans; the non-
borrowed base is the monetary base minus borrowed reserves; and the federal funds rate is the
interest rate on funds loaned overnight between banks.) The central bank pursues this strategy
because it is easier to hit a goal by aiming at target than by aiming at the goal directly.
Specifically, by using intermediate and operating targets, it can more quickly judge whether its
policies are on the right track, rather than waiting until it sees the final outcome of its policies
on employment and the price level.
5.3. Transmissions Mechanism of Monetary Policy: the evidence
To develop a framework for understanding how to evaluate empirical evidence we need to
recognize that there are two basic types of empirical evidence in economics and other
scientific disciplines: structural model evidence examines whether one variable affects another
by using data to build a model that explains the channels through which this variable affects
the other; reduced-form evidence examines whether one variable has an effect on another
simply by looking directly at the relationship between the two variables.

Suppose that you were interested in whether drinking coffee leads to heart disease. Structural
model evidence would involve developing a model that analyzed data on how coffee is
metabolized by the human body, how it affects the operation of the heart, and how its effects
on the heart lead to heart attacks. Reduced-form evidence would involve looking directly at
whether coffee drinkers tend to experience heart attacks more frequently than non-coffee
drinkers.

How you look at the evidence-whether you focus on structural model evidence or reduced-
form evidence-can lead to different conclusions. This is particularly true for the debate
between monetarists and Keynesians. Monetarists tend to focus on reduced-form evidence and
feel that changes in the money supply are more important to economic activity than
Keynesians do; Keynesians, for their part, focus on structural model evidence. To understand
the differences in their views about the importance of monetary policy, we need to look at the
nature of the two types of evidence and the advantages and disadvantages of each.

I. Structural Model Evidence

The Keynesian analysis discussed above is specific about the channels through which the
money supply affects economic activity (called the transmission mechanisms of monetary
policy). Keynesians typically examine the effect of money on economic activity by building a
structural model, a description of how the economy operates using a collection of equations
that describe the behavior of firms and consumers in many sectors of the economy.
These equations then show the channels through which monetary and fiscal policy affect
aggregate output and spending. A Keynesian structural model might have behavioral equations
that describe the workings of monetary policy with the following schematic diagram:

M Y
i /

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 The model describes the transmission mechanism of monetary policy as follows: The money
supply M affects interest rates i, which in turn affect investment spending 1, which in turn
affects aggregate output or aggregate spending Y The Keynesians examine the relationship
between M and Y by looking at empirical evidence (structural model evidence) on the specific
channels of monetary influence, such as the link between interest rates and investment
spending.
II. Reduced-Form Evidence
Monetarists do not describe specific ways in which the money supply affects aggregate
spending. Instead, they examine the effect of money on economic activity by looking at
whether movements in Y are tightly linked to (have a high correlation with) movements in M.
Using reduced-form evidence, monetarists analyze the effect of M on Y as if the economy
were a black box whose workings cannot be seen. The monetarist way of looking at the
evidence can be represented by the following schematic diagram, in which the economy is
drawn as a black box with a question mark:

M ? Y

Now that we have seen how monetarists and Keynesians look at the empirical evidence on the
link between money and economic activity, we can consider the advantages and disadvantages
of their approaches.
Conclusions
No clear-cut case can be made that reduced-form evidence is preferable to structural model
evidence or vice versa. The structural model approach, used primarily by Keynesians, offers
an understanding of how the economy works. If the structure is correct, it predicts the effect of
monetary policy more accurately, allows predictions of the effect of monetary policy when
institutions change, and provides more confidence in the direction of causation between M and
Y If the structure of the model is not correctly specified because it leaves out important
transmission mechanisms of monetary policy, it could be very misleading.
The reduced-form approach, used primarily by monetarists, does not restrict the way monetary
policy affects the economy and may be more likely to spot the full effect of M on Y However,
reduced-form evidence cannot rule out reverse causation, whereby changes in output cause
changes in money, or the possibility that an outside factor drives changes in both output and
money. A high correlation of money and output might then be misleading because controlling
the money supply would not help control the level of output.

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References

Text Books for Macroeconomics I

1. N. Gregory Mankiw, 2007, Macroeconomics 4th edition Worth Publishers USA
2. William H. Branson, 2006 Macroeconomic Theory and Policy
3. Dornbusch, R. and S. Fischer: Macroeconomics

Text Books for Macroeconomics II

1. N. Gregory Mankiw, 2007, Macroeconomics 4th edition Worth Publishers USA
2. William H. Branson, 2006 Macroeconomic Theory and Policy

Major Texts: for Monetary Economics

1. Mishkin, F. S. (1986, 2005), The Economics of Money, Banking, and Financial Markets, Little
Brown and Company, Boston.
2. Goodhart, Charles (1992), Money, Information and Uncertainty, 2nd edition, MacMillan.

Development Economics I
CHAPTER ONE
Economics and Development Studies
Definition
Development: The process of improving the quality of all human lives and capabilities by
raising people‘s levels of living, self-esteem, and freedom. Developing countries: Countries
of Asia, Africa, the Middle East, Latin America, and Eastern Europe that are presently
characterized by low levels of living and other development deficits.
The Nature of Development Economics
Traditional economics: An approach to economics that emphasizes utility, profit
maximization, market efficiency, and determination of equilibrium. It is concerned primarily
with the efficient, least-cost allocation of scarce productive resources and with the optimal
growth of these resources over time so as to produce an ever-expanding range of goods and
services. It assumes economic ―rationality‖ and a purely materialistic, individualistic, self-
interested orientation toward economic decision making. Political economy: The attempt to
merge economic analysis with practical politics—to view economic activity in its political
context. Development economics: The study of how economies are transformed from
stagnation to growth and from low income to high-income status, and overcome problems of
absolute poverty.

The meaning of Economic growth and development

According to professor Bonne, Development requires and involves some sort of direction,
regulation and guidance to generate the forces of expansion and maintain them. According to
Maddison, ―The raising of income levels is generally called economic growth, in rich
countries, and in poor ones it is called economic development". Even though economic
growth and development are sometimes used synonymously in economic discourse,
economic growth refers to a rise in per capita GDP, whereas economic development is more
than economic growth.
Economic development implies (in addition to the rise in per capita income) fundamental
change in the structure of the economy. That is, a falling share of agriculture in GDP, a rising
share of industry in GDP and rising share of population living in cities (urban areas) rather
than in rural areas.

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 Furthermore, Economic development also implies that the country must participate in the
process that brought the major structural change or changes in income. In general,
Development embraces the major economic and social objectives and values that societies
strive for. According to Todaro: DEV is ―conceived as a multi-dimensional process involving
major changes in social structures, popular attitudes, and national institutions, as well as the
acceleration of economic growth, the reduction of inequality (and unemployment), and the
eradication of absolute poverty‖.
Core values of development
Life-sustenance: life-sustenance is concerned with the provision of basic needs. No country
can be regarded as fully developed if it cannot provide its entire people with such basic needs
as housing, clothing, food and minimum education. According to this approach when the
basic needs (i.e. food, shelter, health minimal education and protection) absent or in a critical
short supply we cannot say the country has fully developed. It implies that economic
development is a necessary condition to provide people with basic needs.
Self-esteem: this is concerned with the feeling of self-respect and independence or not being
used as a tool by others for their own need. no country can be regarded as fully developed if it
is exploited by others.
Freedom from servitude: Freedom is ability of people to determine their destiny. It involves
an expanded range of choices for societies and their members together with a minimization of
external constraints in the pursuit of devolvement. No man is free if she/he cannot choose; if
she/he is imprisoned by living on the margin of subsistence with no education and no skills.
The Objectives of Development
To increase the availability of basic life-sustaining goods like food, shelter, health and
protection; To generate greater individual and national self-esteem; and To expand the
range of economic and social choices available to individuals and the nation.
1.3. Current Interest in Development Economics
A number of factors can be pointed out that account for this change in attitude and upsurge of
interests in the economics of development and the economies of poor nations is due to. The
factors are Academic interest in development; the awareness of developing countries about
their backwardness and their demand for a new international economic order; and the
awareness of the world in general and developed countries in particular about the mutual
interdependence of the world economy.
Alternative Development
Among the developed alternative indicators the major once are the following: Human
Development Index (HDI) developed by UNDP, the Human Poverty Index, and Physical
quality of life index
The Human Development Index (HDI)
Human Development Index (HDI) –is an index measuring national socioeconomic
development, based on measures of life expectancy at birth, educational attainment, and
adjusted real per capita income. From the definition of HDI we can have three components,
which are essential in the construction and refinement of a Human Development Index. These
include: Longevity-measured by life expectancy at birth; Measure of educational attainment-
knowledge as measured by a weighted average of adult literacy (two-thirds) and mean years
schooling (one-third weight) that is combination of primary, secondary and Tertiary level
enrollments; and Standards of living: measured by real per capita GDP. HDI ranges from 0 to
1.

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The HDI ranks countries into three groups: low human development (0.0 to 0.49), medium
human development (0.50 to 0.79), and high human development (0.80 to 1.00).
Human Poverty Index ( HPI)
The Human Poverty Index (HPI) was an indication of the standard of living in a country,
developed by the United Nations (UN). It was first reported as part of the Human
Development Report in 1997. In 2010 it was supplanted/replaced by the UN's
Multidimensional Poverty Index. MPI reveals a different pattern of poverty than income;
poverty as it illuminates a different set of deprivations. It is a composite measure focuses on
dimensions of deprivations. The HPI for developing countries is based on three main indices:
a) The percentage of the population not expected to survive to the age of 40 (P1), b) The
adult illiteracy rate (P2), and c) A deprivation index based on an average of three variables: 1.
The percentage of the population without access to safe water; 2. the percentage of
population without access to health service; and 3. the percentage of the underweight children
under five years old (P3)
Physical Quality of Life Index (PQLI)
PQLI is an attempt to measure the quality of life or well-being of a country. The value is the
average of three statistics. Basic literacy rate, infant mortality, and life expectancy obstacles
to development of Africa. There are indeed two fundamental problems which may explain
why these economies are either stagnant or in regression.
 Internal Causes: Inability to solve internal conflicts, Inter-state conflicts including boarder
disputes, Administrative inefficiency, Inappropriate development models, Unrealistic
development strategies, Lack of viable institutions, Ethnicity and Political instability, The
existence of governments without legitimacy, Financial bureaucratic and political
corruption, Lack of transparency in public transactions and lack of accountability in
public action, Lack of trained people to educate and advise farmers, and Adverse weather
conditions.
 External Causes: The disturbing effects of the oil price rises, Policies advocated by the
WB and IMF, The burden of international debt and interest rate, Lack of adequate capital
flow and transfer of technology, and Erection of high tariff barriers.
The Basic Requirements for Development
The African region contains the growing world‘s share of absolute poor with little power to
influence the allocation of resources.
 Peace and Security: Political terror has systematically undermined both development
and security; and Peace is one of the preconditions for economic growth and economic
development.
 Governance and Leadership: In order for Africans to develop, they must be part of the
decision making process; Good governance enhances democracy as well as efficiency in
the economy; and this is important so that African people should claim ownership and
inclusive participation in globalization.
 Economic Growth: Export led growth is a development strategy that has been employed
with remarkable success in some parts of the world, especially Asia.
 Global Interdependence: Globalization is a process of integrating economic decision
making such as the consumption, investment and saving process all across the world; It is
a global market in which all nations are required to participate; and thus, for Africa‘s
development and confronting the 21st century, challenges must be ready and prepared for
globalization, the interdependence of states.
Chapter two
2.1. Common Characteristics of Developing Countries

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There are seven broad categories by which we can classify the common characteristics of
developing countries.
 Low levels of living characterized by low incomes, high inequality, poor health and
inadequate education. Low levels of living are manifested qualitatively and
quantitatively in the form of low incomes (poverty), inadequate housing, poor health and
limited or no education, high infant mortality, low life and work expectancy, and in many
cases, a general sense of sickness and hopelessness.
 Low levels of Productivity. In addition to low levels of living, relatively low levels of
labor productivity characterize developing countries. The concept of a production
function is often used to describe the way in which societies go about providing for their
material needs. But the mechanical technical concept of a production function for
example; Q= f (L, k) where Q = output, L = Labor and K = Capital, must be
supplemented by a broader conceptualization that includes among its other inputs
managerial competence, worker motivation, and institutional flexibility. Throughout the
developing world, levels of labor productivity (output per worker) are extremely low
compared with those in developed countries. This can be explained by a number of basic
economic problems. For example, the principle of diminishing marginal productivity
states that, if increasing amounts of a variable factor (labor) are applied to fixed amounts
of other factors (e.g. Capital, land, materials) , the extra or marginal product of the
variable factor declines beyond a certain number. Therefore, low levels of labor
productivity can therefore be explained by the absence or severe lack of ―Contemporary‖
factor inputs such as physical capital or experienced management in LDCs.
 To raise productivity, according to this argument, domestic savings and foreign finance
must be mobilized to generate new investment in physical capital goods and build up the
stock of human capital (e.g. Managerial skills) through investment in education &
training, Institutional changes are also necessary to maximize the potential of this new
physical and human investment. These charges might include such diverse activities as
the reform of land tenure, corporate tax, credit and banking structures; the creation or
strengthening of an independent, honest, and efficient administrative service, and the
restructuring of educational and training program to make them more appropriate to the
needs of the developing societies.
 High rates of population growth and dependency burden: Developing countries are
not only characterized by higher rate of population growth, but greater dependency
burdens than rich nation. Dependency burden is the proportion of the total population
aged 0 to 15 and 65 and above, which is economically unproductive and therefore not
counted in the labor force.
 High and rising levels of unemployment and underemployment: Underutilization of
labor is manifested in two forms. a) Open unemployment those people who are able and
often to work but for whom no suitable job is available. b) Underemployment those
people who work less than they could.
 Significant dependence on agricultural production and primary product exports.
Agriculture in many LDCs is characterized by high pressure on land, use of very
backward technology, low saving and investment and hence poor productivity. A large
majority of the peasants live in object poverty and the rate of literacy is also very poor.
The land is usually scattered and the fragmented and the distribution of land ownership is
disorganized in most cases.
 Dominance, dependence and Vulnerability in international relations. The dominant
power of the rich nations to control the pattern of international trade. Their ability to

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 dictate the terms in which technology, foreign aid and private capital are transferred to
developed Nations.

Chapter Three
The linear stages of growth
The liner stages of growth were derived largely from the experience of how present
developed countries were transferred from agrarian economy to modern economy. Theorists
of the 1990s and early 1960s viewed the process of development as a series of successive
stages of economic growth through which all countries must pass. It was primarily an
economic theory of development in which the right quantity and mixture of saving,
investment, and foreign aid were all that was necessary to enable developing countries to
proceed along an economic growth path that historically had been followed by the more
developed countries
We are going to divide the linear stages of growth in to three main models of growth:
Namely,
1. Rostow's stages of growth, 2. The Harrod-Domar growth model and 3. The Solow
growth model.
Rostow's stages of growth
This model is highly influenced by Economist called Walt Rostow. According to the Rostow
doctrine, the transition from underdevelopment to development can be described in terms of a
series of steps or stages through which all countries must proceed. Rostow identified stages
of economic growth that societies have to pass through as follows. The traditional society;
Pre-condition for the takeoff; Take-off stage; Drive to maturity and stages of self-sustained
growth and The age of high consumption-
Traditional society or Pre-Industrial stage.
Traditional Society Characterized by The economy is dominated by subsistence activity;
existence of barter; Agriculture is the most important industry Output is consumed by
producers; it is not traded nor recorded; Production is labor intensive using only limited
quantities of capital; Technology is limited; resource allocation is determined very much by
traditional methods of production; People stick to age old customs and traditions output per
worker is very low and doesn‘t change from time to time; In this stage, there may be craft
industries with strong social stratification; and The world is in this stage before 19th century
―Industrial Revolution"
Transitional Stage (Preconditions for Takeoff
Development of mining industries; Increase in capital use in agriculture; Necessity of
external funding; some growth in savings and investment; increased specialization generates
surpluses for trading; emergence of a transport infrastructure to support trade; Entrepreneurs
emerge as incomes, savings and investment grow; External trade also occurs concentrating on
primary products; strong central government encourages private enterprise; in this stage the
economy is more open to modern technology and preparing itself for takeoff; a start of
construction of roads and railways, growing export, new political and economic elites and
high external influence; and Investment ranged around 5% of the GNP in this stage.
The take-off stage

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Increasing industrialization; further growth in savings and investment; some regional growth;
Number employed in agriculture declines; industrial growth may be linked to primary
industries. The level of technology required will be low; Industrialization increases with
workers switching from the agricultural sector to the manufacturing sector; Growth is
concentrated in a few regions of the country and within one or two manufacturing industries;
The level of investment reaches over 10% of GNP; People save money; barriers to growth are
overcomed and growth becomes a normal condition at least in one sector of the economy
(the leading sector); political, social and institutional setup favors dynamic growth; The
growth is self-sustaining as investment leads to increasing incomes in turn generating more
savings to finance further investment; and a country may be in the take-off period for two to
three decades.
Drive to Maturity
As the economy matures, technology plays an increasing role in developing high value added
products. Growth becomes self-sustaining – wealth generation enables further investment in
value adding industry and development Industry more diversified. Increase in levels of
technology utilized; the economy is diversifying into new areas; technological innovation is
providing a diverse range of investment opportunities; the economy is producing a wide
range of goods and services and there is less reliance on imports; urbanization increases; and
technology is used more widely.
High Mass Consumption
Service sector dominates the economy –i.e. banking, insurance, finance, marketing,
entertainment, leisure and so on; High output levels, Mass consumption of consumer durable
goods; High proportion of employment in service sector; In this last stage, the per capital
income becomes so high that the consumption transcends beyond food, clothes and shelter to
goods of comforts and luxuries or a mass scale urbanization and industrialization change the
values of the society and development. In this stage people do not feel any pinch of shortages.
I.e. Very high levels of consumption and physical quality of life are achieved. The economy
is geared towards mass consumption, and the level of economic activity is very high;
Technology is extensively used but its expansion slows; the service sector becomes
increasingly dominant; Urbanization is complete; and increased interest in social welfare.
The Harrod-Domar Growth model
The model takes its name from a synthesis of analyses of the growth process by two
economists, sir Roy Harrod of Britain and E.V. Domar of the United States. It is based on
the experience of advanced economies. Economic growth can be thought of a result of
abstention from current consumption i.e. saving matter. Consider a farmer who needs only
sorghum seed to produce what he requires for his decent life. If he wants to increase
output more than he used to produce, all he needs to do is increase the amount of seed by
foregoing current consumption. The act of increasing the stock of seed is investment while
the total accumulated level of seed is capital stock. In general, capital stock is the machinery,
equipment, and the like which is used to produce output, and investment is the flow of output
to increase or maintain capital stock. Current output (Yt) is the sum of what is consumed (Ct)
and saved ( St) Yt = Ct +St Assuming that what is saved is invested(It). The Harod-Domar
equation s/ θ = g +δ relates growth of an economy to two fundamental variables; the ability of
the economy to save( s) and the capacity( efficiency) of capital to produce (θ ) low capital
output ratio.
The Solow Growth Model
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The Solow growth model which is the formal starting point of modern growth theory is based
on two fundamental equations. Production function (from the supply side) and Capital
accumulation equation (from the demand side). He used the Cobb-Douglass production
function = 𝐾𝛼𝐿1− Where Y= output, K = capital, L = labor.

Assumptions:

1. Constant returns to scale: The production function is homogenous of degree one. That is,
it has a constant returns to scale, and as such scaling up of inputs by a factor z scales up
output by the same factor z.
2. Diminishing returns to factor inputs: As factor inputs (labor Economic Growth and
capital) increase, output increases but the rate at which output increases tends to decline
as more of each input is used while either of the two is held to be constant.
3. Labor force equals population

Steady State Equilibrium

By expanding our model to include population growth our model more closely resembles the
sustained economic growth observable in much of the real world. To see how population
growth affects the steady state we need to know how it affects the accumulation of capital per
worker. When we add population growth (n) to our model the change in capital stock per
worker becomes Δk = i – (δ+n)k. As we can see population growth will have a negative
effect on capital stock accumulation. We can think of (δ+n)k as break-even investment or the
amount of investment necessary to keep capital stock per worker constant. Our analysis
proceeds as in the previous presentations. To see the impact of investment, depreciation, and
population growth on capital we use the (change in capital) formula from above, Δk = i –
(δ+n)k. substituting for (i) gives us, Δk = s*f(k) – (δ+n)k.
Steady State Equilibrium with population growth
At the point where both (k) and (y) are constant it must be the case that, Δk = s*f(k) – (δ+n)k
= 0 or, s*f(k) = (δ+n)k this occurs at our equilibrium point k*.
The impact of population growth
Like depreciation, population growth is one reason why the capital stock per worker shrinks.
The model predicts that economies with higher rates of population growth will have lower
levels of capital per worker and lower levels of income.
The efficiency of labor
We rewrite our production function as Y=F(K,L*E) where ―E‖ is the efficiency of labour.
―L*E‖ is a measure of the number of effective workers. The growth of labour efficiency is
―g‖.
Our production function y=f(k) becomes output per effective worker since y=Y/(L*E) and
k=K/(L*E). With this augmentation ―δk‖ is needed to replace depreciating capital, ―nk‖ is
needed to provide capital to new workers, and ―gk‖ is needed to provide capital for the new
effective workers created by technological progress.
Steady State Equilibrium with population growth and technological progress
At the point where both (k) and (y) are constant it must be the case that, Δk = s*f(k) –
(δ+n+g)k = 0 or, s*f(k) = (δ+n)k this occurs at our equilibrium point k*.
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The impact of technological progress
Suppose the worker efficiency growth rate changes from g to g . This shifts the line
1 2
representing population growth, depreciation, and worker efficiency growth upward. At the
new steady state k2* capital per worker and output per worker are lower. The model predicts
that economies with higher rates of worker efficiency growth will have lower levels of capital
per worker and lower levels of income.
Effects of technological progress on the golden rule
With technological progress the golden rule level of capital is defined as the steady state that
maximizes consumption per effective worker. Following our previous analysis steady state
consumption per worker is c* = f(k*) – (δ + n + g)k*
To maximize this MPK = δ + n + g or MPK – δ = n + g. That is, at the Golden Rule level of
capital, the net marginal product of capital MPK – δ, equals the rate of growth of total output,
n+g.

Structural-change theory

They hypothesis that under development is due to underutilization of resources arising from
structural or institutional factors that have their origins in both domestic and international
dualism. Development therefore requires more than just accelerated capital formation.
Structural transformation: is the process of transforming an economy in such a way that the
contribution to national income by the manufacturing sector eventually surpasses the
contribution by the agricultural sector.

The Lewis Theory of Development

Prof. Arthur Lewis has developed a very systematic theory of economic development with
unlimited supply of labour. Lewis' model starts with the assumption of a dual economy with a
modern industrial sector and a traditional subsistence sector. Lewis believed that in the
traditional sector of many underdeveloped countries there is unlimited supply of labour at
subsistence wage. Lewis two-sector model: A theory of development in which surplus labor
from the traditional agricultural sector is transferred to the modern industrial sector, the
growth of which absorbs the surplus labor, promotes industrialization, and stimulates
sustained development.

Surplus Labour means the existence of such a large population in the rural sector so that the
marginal productivity of labour has fallen to zero. This condition is also called disguised
unemployment. The essence of the development process in this type of an economy is the
transfer of labor resources from the agricultural sector where they add nothing to production
to the more modern industrial sector, where they create a surplus. Economic development
takes place when capital accumulates as a result of withdrawal of surplus labour from the
subsistence to the modern industrial sector. In the Lewis two-sector model of economic
development, surplus labor refers to the portion of the rural labor force whose marginal
productivity is zero or negative.

Dualism Theory

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Dualism is the coexistence of two situations or phenomena (one desirable and the other not)
that are mutually exclusive to different groups of society. Dualism represents the
existence and persistence of increasing divergences between rich and poor nations and rich
and poor peoples at all levels. The concept embraces four key arguments: Superior and
inferior conditions can coexist in a given space at given time. The coexistence is chronic and
not transitional. The degrees of the conditions have an inherent tendency to increase Superior
conditions serve to develop under development.

The theory of big –push

The theory of the big push is developed by prof. P.N. Rosesnstien-Rodan the most
famous coordination failures model in the development. The first factory can sell some of its
goods to its own workers, but no one spends all of one‘s income on a single good. Each time
an entrepreneur opens a factory, the workers spend some of their wages on other products. So
the profitability of one factory depends on whether another one opens, which in turn depends
on its own potential profitability, and that in turn depends on the profitability of still other
factories. Such circular causation should now be a familiar pattern of a coordination failure
problem. Big push A concerted, economy wide, and typically public policy–led effort to
initiate or accelerate economic development across a broad spectrum of new industries and
skills. It states that a big push or a large comprehensive program is needed to overcome
obstacles of growth It also states that proceeding ―bit by bit‖ will not launch the economy
successfully on the development path rather a minimum amount of investment is a necessary
condition for development. Moreover, the first factory has to train its workers, who are
accustomed to a subsistence way of life. The cost of training puts a limit on how high a wage
the factory can pay and still remain profitable. But once the first firm trains its workers, other
entrepreneurs, not having to recoup training costs, can offer a slightly higher wage to attract
the trained workers to their own new factories. However, the first entrepreneur, anticipating
this likelihood, does not pay for training in the first place. No one is trained, and
industrialization never gets under way. The big push is a model of how the presence of
market failures can lead to a need for a concerted economy wide and probably public-policy-
led effort to get the long process of economic development under way or to accelerate it. Put
differently, coordination failure problems work against successful industrialization, a
counterweight to the push for development. A big push may not always be needed, but it is
helpful to find ways to characterize cases in which it will be.

The Balanced Growth Theory

This theory was advocated mainly by Rosenstein-Rodan (1943), Ragnar NurKse (1953) and
Arthur Lewis (1954). But their view about balanced growth theory was different. To some
writers, balanced growth means investing in a lagging sector of the national economy or
industry so as to ensure that it catches up with others. To others, balanced growth implies that
investment takes place simultaneously in all sectors of the national economy. Still to others,
it implies the balanced development of agricultural and industrial sectors of the
economy. To this extent, balanced growth calls for maintaining the balance between the
different consumer and capital good industries. It also calls for ensuring balance between
agriculture and industry and between the domestic and export sectors of the national
economy. Additionally, it requires balance between social and economic overheads and
directly productive investment. Moreover, the economists in favor of the balanced growth
postulated the balance between supply side and demand side. The supply side consists of
simultaneous development of all interrelated sectors, i.e., intermediate goods, raw materials,
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power, agriculture, transport, and consumer goods industries. The demand side comprises
provision of employment opportunities which increase income and thus demand of the
consumers. To sum up in the words of Lewis, ―in development Program all sectors of the
economy should grow simultaneously so as to keep a proper balance between industry and
agriculture and between production for home consumption and production for exports‖.

Unbalance Growth
The theory of unbalanced growth is the opposite of the doctrine of balanced growth. The
dissatisfaction with the theoretical underpinnings of the balanced growth theory gave rise to a
new school of thought that of unbalanced growth which has an intellectual as well as a
practical appeal. The deliberate unbalancing of the economy in accordance with a pre-
designed strategy is the best way to achieve rapid economic development in the less
developed countries. Investments in strategically selected industries or sectors of the
economy, will lead to new investment opportunities and so pave the way for further
economic development. According to this theory investment should be made in selected
sectors rather than simultaneously in all sectors of the economy.
The international-dependence model
The dependency theory states that the dependence of LDCs on DCs is the main cause for
underdevelopment of the former. Definition: dependency is a situation in which the economy
of certain countries is conditioned by the development and expansion of another economy to
which the former is subjected. It is explained in the following characteristics:
A. Dependency a historical international process: - the present economic and socio-
political condition prevailing in LDCs is result of a historical international process.
B. Dependency on foreign capital: LDCs depend on DCs on foreign capital, the foreign
investors exploit LDCs by insisting on the choice of projects, making decisions on
pricing, supply of equipment‘s, knowhow, and personnel etc. The dependency on foreign
capital leads to a much higher outflow in the form of declared profits, royalties, transfer
of pricing, payment of principal and interest to foreign investors of DCs.
C. Technological dependence; LDCs use excessively capital intensive technologies
imported from DCs. These technologies are inappropriate to the production and
consumption of LDCs.
D. Trade and Unequal Exchange: LDCs export primary products with inelastic demand
and import manufactured goods. NB. Within the international dependency revolution,
there are three major streams of thought: the neocolonial dependence model, the false-
paradigm model, dualistic-development thesis.
Neocolonial dependence model: A model whose main proposition is that
underdevelopment exists in developing countries because of continuing exploitative
economic, political, and cultural policies of former colonial rulers toward less developed
countries.
False-paradigm model: The proposition that developing countries have failed to
develop because their development strategies (usually given to them by Western
economists) have been based on an incorrect model of development, one that, for
example, overstressed capital accumulation or market liberalization without giving due
consideration to needed social and institutional change. The false-paradigm model,
attribute underdevelopment to faulty and inappropriate advice provided by well-meaning
but often uninformed, biased, and ethnocentric international expert‖ advisers from
developed- country assistance agencies and multinational donor organizations. These

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 experts are said to offer complex but ultimately misleading models of development that
often lead to inappropriate or incorrect policies.
The Neoclassical Counterrevolution: The 1980s resurgence of neoclassical free-market
orientation toward development problems and policies, counter to the interventionist
dependence revolution of the 1970s. The central argument of the neoclassical
counterrevolution is that underdevelopment results from poor resource allocation due to
incorrect pricing policies and too much state intervention by overly active developing-
nation governments. the neoclassical counterrevolutionaries argue that the developing
world is underdeveloped not because of the predatory activities of the developed world
and the international agencies that it controls but rather because of the heavy hand of the
state and the corruption, inefficiency, and lack of economic incentives that permeate the
economies of developing nations. What is needed, therefore, is not a reform of the
international economic system, a restructuring of dualistic developing economies, an
increase in foreign aid, attempts to control population growth, or a more effective
development planning system.
Rather, it is simply a matter of promoting free markets and laissez-faire economics within
the context of permissive governments that allow the ―magic of the market place‖ and the
―invisible hand‖ of market prices to guide resource allocation and stimulate economic
development.
New growth theory: The theory that our unlimited wants may lead us to ever greater
productivity and perpetual economic growth. According to new growth theory, real GDP
per person grows because of the choices people make in the pursuit of profit. New growth
theory predicts that national growth rates depend on national incentives to save, invest,
accumulated human capital, and innovate. According to neo-classical theory, the low
capital-labor ratios of Third world countries promise exceptionally high rates of return on
investment. According to neoclassical theory, the low capital labor ratio of third world
country promise exceptional high rate of return on investment. The free market reforms
imposed on highly indebted countries by the World Bank and the international monetary
fund should thus have promoted higher investment, rising productivity, and improved
standard of living. Yet even after prescribed liberalization of trade and domestic markets,
many LDCs experienced little or no growth and failed to attract new foreign investment
or to halt the flight of domestic capital. The new growth theory (endogenous growth)
provides a theoretical framework for analyzing endogenous growth, persistent GNP
growth that is determined by the system governing the production process rather than by
forces outside that system.

CHAPTER FOUR
Economics of Growth, Capital, labor, and Technology
Three factors or components of economic growth are of prime importance in any society: 1.
capital accumulation, including all new investments in land, physical equipment, and human
resources, 2. growth in population and hence eventual growth in the labor force, and 3.
Technological progress.
a) What is Capital Accumulation?
Capital accumulation results when some proportion of present income is saved and invested
in order to augment future output and income. New factories, machinery, equipment, and
materials increase the physical capital stock of a nation (the total net real value of all
physically productive capital goods) and make it possible for expanded output levels to be
achieved. These directly productive investments are supplemented by investments in what is
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known as social and economic infrastructure - roads, electricity, water and sanitation,
communications, and the like- which facilitates and integrates economic activities. Capital
accumulation may add new resources (e.g., the clearing of unused land) or upgrade the
quality of existing resources (e.g., irrigation, fertilizer, pesticides).
b) Population And Labor Force Growth
Population growth, and the associated eventual increase in the labor force, has traditionally
been considered a positive factor in stimulating economic growth. A larger labor force means
more productive workers, and a large overall population increases the potential size of
domestic markets. However, it is questionable whether rapidly growing supplies of workers
in surplus-labor developing countries exert a positive or a negative influence on economic
progress. Obviously, it will depend on the ability of the economic system to absorb and
productively employ these added workers-an ability largely associated with the rate and kind
of capital accumulation and the availability of related factors, such as managerial and
administrative skills. Given your initial understanding of these first two fundamental
components of economic growth and disregarding technology, Let us see how they interact
via the production possibility curve to expand society‘s potential total output of all goods.
c) Technological Progress
Technological progress, for many economists is the most important source of economic
growth. In its simplest form, technological progress results from new and improved ways of
accomplishing traditional tasks such as growing crops, making clothing, or building a house.
There are three basic classifications of technological progress: neutral, laborsaving, and
capital-saving.
i. Neutral Technological progress
In terms of production possibility analysis, a neutral technological change that, say, doubles
total output is conceptually equivalent to a doubling of all productive inputs. A neutral
technological progress allows producers to produce more with same capital labor ratio (do
not save relatively more of either input).
ii. Labor saving Technological Progress
The technological progress uses more capital relative to labor. Computers, the Internet,
automated looms, high-speed electric drills these and many other kinds of modern machinery
and equipment can also be classified as product of labor-saving technological progress.
Technological progress over the last century has consisted largely of rapid advances in labor
saving technology is for producing everything from beans to bicycles to bridges.
iii. Capital-saving Technological Progress
The technological progress uses more labor relative to capital. Such progress is more efficient
(lower-cost) labor-intensive methods of production- for instance foot- operated bellows
pumps, and back mounted mechanical sprayers for small-scale agriculture. In the labor
abundant (capital- scarce), Developing countries, such as Ethiopia, capital saving
technological progress is what is needed most.

Chapter Five:
Inequality, Poverty and Development
Measurement of Income inequality
Economists usually like to distinguish between two principal measures of income distribution
for both analytic and quantitative purposes.

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 a. The personal or size distribution of income
b. The functional or distributive factor share distribution of income.
a) Size Distributions
The personal or size distribution of income is the measure most commonly used by
economists. It simply deals with individual persons or households and the total income they
receive. The way in which that income was received is not considered. Personal distribution
of income (size distribution of income) The distribution of income according to size class of
persons, for example, the share of total income accruing to the poorest specific percentage or
the richest specific percentage of a population without regard to the sources of that income.
Economists and statisticians, therefore, like to arrange all individuals by ascending personal
incomes and then divided the total population in to distinct groups or sizes. A common
method is to divide the population in to successive quintiles (fifths) or deciles (tenths)
according to the ascending income levels and then determine what proportion of the total
national income is received by each income group.
Lorenz Curve
The Lorenz curve shows the actual quantitative relationship between the percentages of
income recipients and the percentage of the actual income they did in fact receive during, say,
a given year. The more the Lorenz line curves is away from the diagonal (perfect equality
line), the greater the degree of inequality represented. The extreme case of perfect inequality
( i.e. a situation in which one person receives all of the national income while ever body else
receives nothing) would be represented by the congruence of the Lorenz curve with the
bottom horizontal and right hand vertical axes. Because no country exhibits either perfect
equality or perfect inequality in its distribution of income, the Lorenz curves for different
countries will lie somewhere to the right of the diagonal The greater the degree of inequality,
the greater the bend and the closer to the bottom horizontal axis the Lorenz curve will be.
(See the Lorenz curve).
Gini Coefficient
A final and very convenient short hand summary measure of the relative degree of income
inequality in a country can be obtained by calculating the ratio of the area between the
diagonal and the Lorenz curve divided by the total area of the half square in which the curve
lies. Gini coefficients are aggregate inequality measures and can vary anywhere from 0
(perfect equality) to 1 (perfect inequality). Gini coefficients for countries with highly
unequal income distributions typically lies between 0.50 and 0.70 while for countries with
relatively equitable distributions, it is on the order of 0.20 to 0.35.
b) Functional Distribution
This one is sometimes referred as factor share distribution of income. It is the distribution of
income to factors of production without regard to the ownership of the factors. It explains the
share of total national income that each factor of production (land, labor and capital) receives.
Instead of looking at individuals as separate entities, the functional distribution inquiries into
the percentage that labor receives as a whole and compares this with the percentages of total
income distributed in the form of rent, interest, and profit (i.e. the returns to land and
financial and physical capital).
Measuring Poverty
Measuring Absolute Poverty

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Absolute poverty: the situation of being unable or only barely able to meet the subsistence
essentials of food, clothing, and shelter. Extent of absolute poverty can be defined as the
number of people who are unable to command sufficient resources to satisfy basic needs.
They are counted as the total number living below a specified minimum level of real income
an international poverty line. The Absolute Poverty Headcount H simply adds the number of
people whose income is below an agreed upon poverty line. The Headcount index H/N
divides this number by the population.
Poverty, Inequality, and Social Welfare
First, extreme income inequality leads to economic inefficiency. At any given average
income, the higher the inequality, the smaller the fraction of the population that qualifies for a
loan or other credit. Lack of collateral, low-income individuals cannot borrow money; they
generally cannot adequately educate their children or start and expand a business. Moreover,
with high inequality, the overall rate of saving in the economy tends to be lower, because the
highest rate of marginal savings is usually found among the middle classes.
The second reason to be concerned with inequality is that extreme income disparities
undermine social stability and solidarity. Also, high inequality strengthens the political power
of the rich and hence their economic bargaining power. Usually this power will be used to
encourage outcomes favorable to them. High inequality facilitates rent seeking, including
actions such as excessive lobbying, large political donations and bribery. When resources are
allocated to such rent-seeking behaviors, they are diverted from productive purposes that
could lead to faster growth. The poor try revolution while the rich try corruption and rent-
seeking to retain power.
Finally, extreme inequality is generally viewed as unfair. Would you vote for an income
distribution that was more equal or less equal than the one you see around you? If the degree
of equality had no effect on the level of income or rate of growth, most people would vote for
nearly perfect equality. Of course, if everyone had the same income no matter what, there
would be little incentive to work hard, gain skills, or innovate. As a result, most people vote
for some inequality of income outcomes, to the extent that these correspond to incentives for
hard work or innovation.
Growth versus Income Distribution
The debate about the relationship between economics distribution takes many forms. The key
arguments are the traditional argument and the counter argument.
a) The traditional Argument: Factor shares, saving and Economic growth.

Although much of economic analysis has been strangely silent on the relationship between
economic growth and the resulting distribution of income, a large body of theory in essence
asserts that highly unequal distributions are necessary conditions for generating rapid growth.
The basic economic argument to justify large income in equalities was that high personal and
corporate incomes were necessary conditions of saving, which made possible investment and
economic growth. If the rich save and invest significant portions of their incomes while the
poor spend all their income on consumption goods, and if GNP growth rates are directly
related to the proportion of national income saved, then apparently an economy characterized
by highly unequal distributions of income would save more and grow faster than one with a
more equitable distribution of income.
b) Counterargument
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Certain degree of redistribution can enhance saving and push up growth rate. Which
argument to follow depends on the relationship between marginal saving rate and the level
income? Potentially we can have three types of marginal saving rate: Increasing marginal
saving rate, Decreasing marginal saving rate, and Constant marginal saving rate
If the marginal saving rate is increasing, increase in inequality reduces the volume of saving
in the economy. Similarly, if the marginal saving rate is decreasing, the reduction in
inequality increases the saving rate in the economy. In case of constant marginal saving,
inequality does not affect the rate of saving.
The Range of Policy Options: Some Basic Considerations

a) Areas of Intervention
We can identify four broad areas of possible government policy intervention, which
correspond to the following four major elements in the determination of a developing
economy's distribution of income:
Functional distribution-the returns to labor, land, and capital as determined by factor prices,
utilization levels, and the consequent shares of national income that accrue to the owners of
each factor. Change asset and skill inequality: the sources of income inequality. Land reform;
microcredit; basic education, Make taxes more progressive, and Poverty reduction programs:
direct transfers or subsidies for food, education, health, etc.
b) Policy options
Changing relative factor prices, Traditional-sector workers have very low incomes and
minimum-wage laws are seldom enforced, Artificially high modern-sector wages (due to
unions or laws) reduce the growth of the modern sector, condemning more people to poverty
and exclusion, Market-determined wages (which would be lower) in the modern sector would
increase employment and incomes for the poor, and Market-determined cost of capital (which
would be higher) would encourage firms to hire workers rather than buy capital.
 Transfer payments and public provision of goods and services
Make sure it‘s targeted to the poor, Prevent the poor from becoming dependent on it … but
encourage appropriate risk taking, Discourage switching from work to program, and Avoid
resentment by nearly-poor-but-not-enough who are working.
 ―workfare‖ is better than welfare if it
Does not undermine incentives for acquiring human capital needed for private sector jobs,
Increases net benefits – including externalities, Is difficult to identify the needy without work
requirement, There are relatively few poor people, and There less social stigma / political
resentment from workfare. The needs for a ‗package‘ of policies eliminate price distortions:
more efficiency, more employment and less poverty, Structural change in asset ownership
and Progressive taxes and transfers; safety net.

Development Economics II
Chapter one
1. Population Growth and Economic Development: Causes, Consequences, and
Controversies
1.1. The Basic Issue: Population Growth and Quality of Life
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Every year, more than 75 million people are being added to the world‘s population.
Almost all of this net population increase 97% is in developing countries. Increases of
such magnitude are unprecedented. But the problem of population growth is not simply a
problem of numbers. It is a problem of human welfare and of development. Rapid population
growth can have serious consequences for the well- being of all of humanity.
1.2.The Hidden Momentum of Population Growth
The phenomenon population continues to increase, even after a fall in birth rates, because the
large existing youthful population expands the population‘s base of potential parents.
– High birth rates cannot be altered overnight and Age structure of developing country
populations
1.3.The Demographic Transition
The demographic transition is a process of change from a situation with high mortality and
fertility (and constant population), to a situation with low mortality and fertility. The process
is characterized by an initial reduction in mortality rates (increase in life expectancy),
followed with some delay by a reduction in fertility rates. In the interval between the
mortality reductions and the fertility reductions, population tends to experience accelerated
growth (given the increased rate of natural growth). All countries that ultimately achieved a
high level of economic development went through the demographic transition. Therefore, it
is usually thought that the demographic transition is a necessary condition for the
onset or beginning of the process of economic development.
Stage I: High birth rates and death rates, Stage II: Continued high birthrates, declining death
rates, and Stage III: Falling birthrates and death rates eventually stabilizing.
1.4. The Causes of High Fertility in Developing Countries: The Malthusian and
Household Models
The Malthusian Population Trap: Thomas R. Malthus believed that population would expand
as long as food supply allowed. Assumption that the ―passion between the sexes‖ would lead
to increased fertility whenever conditions allowed for it (any improvements in living standard
(due, for example, to good weather) would end up being reflected in a larger population).
Economically, it is as if he assumed that number of children was a ―normal good‖: any
increase in income would be reflected in parents having more children. So he also assumed
that any increase in population would take place at the expenses of living standards. If
population increased for some exogenous reason, some catastrophe was bound to
happen, so that initial level of living standards would end up being restored. Famines, wars,
and epidemics would be the mode of operation of Malthus‘s ―checks‖ This is the classic
Malthusian idea that population tends to grow at a geometric rate, while food supply tends to
grow at an arithmetic rate. In the long run, there‘s not enough food available, and
―positive checks‖ are needed to equilibrate population and food supply.
1.5.The Microeconomic Household Theory of Fertility
The Demand for Children in Developing Countries: First two or three as ―consumer goods‖,
Additional children as ―investment goods‖, Work on family farm, microenterprise, and Old
age security motivation. In the application of this theory to fertility analysis, children are
considered as a special kind of consumption (and in developing countries, particularly low
income countries, investment) good so that fertility becomes a rational economic response to
the consumer‘s (families) demand for children relative to other goods. The usual income and
substitution effects are assumed to apply If other factors are held constant, the desired
number of children can be expected to vary directly with household income, (this direct

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relationship may not hold for poor societies; it depends on the strength of demand for
children relative to other consumer goods and to the sources of increased income, such as
female employment), inversely with the price (cost) of children, and inversely with the
strength of tastes for other goods relative to children.
Some empirical evidence and Implications
Fertility lower if raise women‘s education, role, and status, more female nonagricultural wage
employment, rise in family income levels, reduction in infant mortality, development of old-
age and social security, and expanded schooling opportunities.
1.6. The Consequences of High Fertility: Some Conflicting Perspectives
Population growth: ―It‘s Not a Real Problem‖ The real problem is not population growth but
the following, underdevelopment, world resource depletion and environmental destruction,
population Distribution, and subordination of women. Overpopulation is a Deliberately
Contrived False Issue and population Growth is a Desirable Phenomenon.
―Population Growth Is a Real Problem‖ Extremist arguments: Unrestrained population
increase is seen as the major crisis facing humankind today. It is regarded as the principal
cause of poverty, low levels of living, malnutrition, ill health, environmental degradation, and
a wide array of other social problems. Theoretical arguments: Population growth is
believed to retard the prospects for a better life for the already born by reducing savings rates
at the household and national levels. This in turn further reduces the prospects for any
improvement in the levels of living of the existing generation and helps transmit poverty to
future generations of low-income families.
Chapter Two
2. Human Capital: Education and Health in Economic Development
2.1. The Central Roles of Education and Health
Education plays a key role in the ability of a developing country to absorb modern
technology and to develop the capacity for self-sustaining growth and development.
Moreover, health is a prerequisite for increases in productivity, and successful education
relies on adequate health as well. Thus, health and education are also important components
of growth and development. Their dual role as both inputs and outputs gives health and
education their central importance in economic development.
2.2. Investing in Health and Education: The Human Capital Approach
The analysis of investments in health and education is unified in the human capital approach.
Human capital is the term economists often use for education, health, and other human
capacities that can raise productivity when increased. Initial investments in health or
education lead to a stream of higher future income. The present discounted value of this
stream of future income is compared to the costs of the investment. Private returns to
education are high, and may be higher than social returns.
2.3. Educational Systems and Development
Educational supply and demand: the relationship between employment opportunities and
educational demands.
Demand for Education
Educated students have the prospect of earning significantly more income than uneducated
ones through future employment in the modern sector (the family's private educational
benefits). The educational costs, both direct and indirect, that a student or family must bear.
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The amount of education demanded is thus in reality a derived demand for high-wage
employment opportunities in the modern sector.
Determinants of this derived demand
The wage or income differential, the probability of success in finding modern-sector
employment, the direct private costs of education, and the indirect or opportunity costs of
education
Supply side
On the supply side, the quantity of school places at the primary, secondary, and university
levels is determined largely by political processes, often unrelated to economic criteria.
Social versus private benefits and costs
Typically in developing countries, the social costs of education increase rapidly as students
climb the educational ladder. The private costs of education (those borne by students
themselves) increase more slowly or may even decline. This widening gap between social
and private costs provides an even greater stimulus to the demand for higher education than it
does for education at lower levels. But educational opportunities can be accommodated to
these distorted demands only at full social cost.
Education, Inequality, and Poverty
Studies have demonstrated that contrary to what might have been assumed, the educational
systems of many developing nations sometimes act to increase rather than to decrease income
inequalities. The basic reason for this perverse effect of formal education on income
distribution is the positive correlation between level of education and level of lifetime
earnings.
2.4.The Gender Gap: Women and Education
Young females receive less education than young males in nearly every LDC. Closing this
educational gender gap is economically desirable because: The social rate of return on
women‘s education is higher than that of men in developing countries (why?). Education for
women increases productivity lowers fertility; educated mothers have a multiplier impact on
future generations; and Education can break the vicious cycle of poverty and inadequate
schooling for women.
CHAPTER THREE
2. Rural-urban interaction, migration, and unemployment
2.1.Urbanization: Trends and Projections
The United Nations projects that in 2025, over 4.1 billion, or 80%, of the urban dwellers of
the world will reside in less developed regions. A central question related to the
unprecedented size of these urban agglomerations is how these LDC cities will cope
economically, environmentally, and politically-with such acute concentrations of people.
While it is true that cities offer the cost-reducing advantages of agglomeration economies and
Economies of scale and proximity as well as numerous economic and social externalities
(e.g., skilled workers, cheap transport, social and cultural amenities), the social costs of a
progressive overloading of housing and social services increased crime, pollution, and
congestion, tend gradually to outweigh these historical urban advantages.
2.2. The Role of Cities and The Urban Gigantism Problem

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To a large degree, cities are formed because they provide cost advantages to producers and
consumers through what are called agglomeration economies. Agglomeration economies
Cost reducing advantages to producers and consumers from location in cities and towns,
which take the forms of urbanization economies and localization economies. Urbanization
economies: Agglomeration effects associated with the general growth of a concentrated
geographic region. Localization economies: Agglomeration effects captured by particular
sectors of the economy, such as finance or autos, as they grow within an area.
The Urban Gigantism Problem
In the case of developing countries, the main transportation routes are often a legacy of
colonialism.
Theorists of the dependence school have compared colonial transportation networks to
drainage systems, emphasizing ease of extraction of the country‘s natural resources. In many
cases, the capital city will be located near the outlet of this system on the seacoast. This type
of transportation system is also called a ―hub-and-spoke system,‖ which is especially visible
when the capital city is located in the interior of the country. Many nations inherited a hub-
and-spoke system from colonial times, including many in Africa and Latin America, which
also facilitated movement of troops from the capital to the outlying towns to suppress revolts.
First City Bias
A form of urban bias that has often caused considerable distortions might be termed first-city
bias. The country‘s largest or ―first-place‖ city receives a disproportionately large share of
public investment and incentives for private investment in relation to the country‘s second-
largest city and other smaller cities. As a result, the first city receives a disproportionately and
inefficiently large share of population and economic activity. Some other developing
countries have remarkably outsized first cities, notably Thailand, where Bangkok has a
population about 20 times the size of the second city.
Causes of Urban Gigantism
Why first cities often swelled to such a large multiple of second cities in developing
countries? Overall, urban gigantism probably results from a combination of a hub-and-spoke
transportation system and the location of the political capital in the largest city. This is further
reinforced by a political culture of rent seeking and the capital market failures that make the
creation of new urban centers a task that markets cannot complete. Under Import substitution
industrialization, with a high level of protection, there is much less international trade, and
population and economic activity have an incentive to concentrate in a single city, largely to
avoid transportation costs.
2.3. Economic Model of Rural-Urban Migration
Michael P. Todaro has attempted to develop a theory of rural-urban migration to explain the
apparently paradoxical relationship of accelerated rural-urban migration in the context of
rising urban unemployment.
Starting from the assumption that migration is primarily an economic phenomenon, which for
the individual migrant can be a quite rational decision. Despite the existence of urban
unemployment, the Todaro model postulates that migration proceeds in response to urban-
rural differences in expected income rather than actual earnings. The fundamental premise is
that migrants consider the various labor market opportunities available to them in the rural
and urban sectors and choose the one that maximizes their expected gains from migration.
Expected gains are measured by the difference in real incomes between rural and urban work
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and the probability of a new migrant's obtaining an urban job. The theory assumes that
members of the labor force compare their expected incomes for a given time horizon in the
urban sector (the difference between returns and costs of migration) with prevailing average
rural incomes and migrate if the former exceeds the latter.
The Todaro migration model has four basic characteristics:
1. Migration is stimulated primarily by rational economic considerations of relative benefits
and costs, mostly financial but also psychological.
2. The decision to migrate depends on expected rather than actual urban rural real-wage
differentials where the expected differential is determined by the interaction of two
variables, the actual urban-rural wage differential and the probability of successfully
obtaining employment in the urban sector
3. The probability of obtaining an urban job is directly related to the urban employment rate
and thus inversely related to the urban unemployment rate.
4. Migration rates in excess of urban job opportunity growth rates are not only possible but
also rational and even likely in the face of wide urban rural expected income differentials.
5. High rates of urban unemployment are therefore inevitable outcomes of the serious
imbalance of economic opportunities between urban and rural areas in most
underdeveloped countries.
Lewis Development Model
Lewis two-sector model:- A theory of development in which surplus labor from the
traditional agricultural sector is transferred to the modern industrial sector, the growth of
which absorbs the surplus labor, promotes industrialization, and stimulates sustained
development.
1. The underdeveloped economy consists of two sectors: a traditional, overpopulated rural
subsistence sector characterized by zero marginal labor productivity a situation that
permits Lewis to classify this as surplus labor in the sense that it can be with- drawn from
the traditional agricultural sector without any loss of output and a high-productivity
modern urban industrial sector into which labor from the subsistence sector is gradually
transferred. Surplus labor: - The excess supply of labor over and above the quantity
demanded at the going free-market wage rate. It refers to the portion of the rural labor
force whose marginal productivity is zero or negative.
2. The assumption of the rate of labor transfer and employment creation in the modern
sector is proportional to the rate of modern sector capital accumulation.
3. The assumption of surplus labor exists in rural areas while there is full employment in the
urban areas.
4. The assumption is the notion of a competitive modern sector labor market that guarantees
the continued existence of constant real urban wages up to the point where the supply of
rural surplus labor is exhausted.
5. The speed with which industrial expansion occurs is determined by the rate of industrial
investment and capital accumulation in the modern sector.
6. The laws of diminishing return to scale in the modern industrial sector.
Chapter five
5.1. Role of foreign trade in development
The role of foreign trade can be judged by the following faces:
Foreign trade and economic development
Foreign trade plays very important role in the economic development of any country.
Economic development of a country depends of foreign trade.
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Foreign exchange earning
Foreign trade provides foreign exchange which can be used to remove the poverty and other
productive purposes. Some country also exports a lot of agricultural product to other
countries and imports the capital goods from other countries.
Market expansion
The demand plays very important role in increasing the production of any country. The
foreign trade expands the market and encourages the producers. So it is necessary that we
should sell our product in other countries.
Increase in investment
Foreign trade encourages the investor to increase the investment to produce more goods. So
the rate of investment increases.
Foreign investment
Besides the local investment, foreign trade provides incentives for the foreign investors to
invest in those countries where there is a shortage of investment.
Increase in national income
Foreign trade increases the scale of production and national income of the country. To meet
the foreign demand we increase the production on large scale so GNP also increases.
Decrease in unemployment
With the rise in the demand of goods domestic resources are fully utilized and it increases the
rate of development in the country and reduces the unemployment in the world.
Price stability
Foreign trade helps to bring stability in price level. All those goods which are in shortage and
prices are increasing can be imported and those goods which are surplus can be exported.
There by stopping fluctuation in prices.
Specialization
There is a difference in the quality and quantity of various factors of production in different
countries. Each country adopts the specialization in the production of those commodities, in
which it has comparative advantage. So all trading countries enjoy profit through
international trade.
Remove monopolies
Foreign trade also discourages the monopolies. Where every monopolist increases the prices,
government allows the import of goods to reduce the prices in the country.
Removal of food shortage
We always face the food shortage problem. To remove this food shortage we imported the
wheat many times. So due to foreign trade we are solving this problem for many years.
Agricultural development
Agricultural development is the back bone in our economy. Foreign trade has played very
important role for the development of our agriculture. Every year we export coffee, flower,
fruits and vegetables to other countries. The export of goods makes our farmer more
prosperous. It inspires the spirit of development in them.
Import of consumer goods
We import the various consumer goods from other countries, which are not produced inside
the country. Today the shortage of any commodity can be removed through international
trade.
To improve quality of local products
Foreign trade helps to improve quality of local products and extends market through changes
in demand and supply as foreign trade can create competition with the rest of the world.
Competition with foreign producers
We can compete with the foreign producers in foreign trade so it improves the quality and
reduces the cost of production. It is also an advantage of foreign trade.
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Useful for the world peace
Today all the countries are tied in trade relations with each other. Foreign trade also
contributes to peace and prosperity in the world.
Import of capital goods and technology
The inflow of capital goods and technology in the less developed countries has increased the
rate of economic development, and this is due to foreign trade.
Import substitution
These countries not only produce import substitute, but also reduce deficit in balance of
payment of their countries.
Dissemination of knowledge
Foreign trade is also responsible for dissemination of knowledge and learning from
developed countries to under developed countries.
Factors productivity
Through foreign trade the productivity of labour and capital and organization increases.
Demand make them mobile on national as well as international level which helps
underdeveloped countries to develop and maintain a high level of growth of developed
countries.
5.2. Demand Elasticities and Export Earning Instability
In the case of primary products, the income elasticity of demand is relatively low. The
percentage increase in quantity of primary agricultural products and most raw materials
demanded by importers (mostly rich nations) will rise by less than the percentage increase in
their GNIs. Manufactured goods, income elasticity is relatively high. Moreover, the price
elasticity of demand for (and supply of) primary commodities also tends to be quite low. Any
shifts in demand or supply curves can cause large and volatile price fluctuations. Together
these two elasticity phenomena contribute to what has come to be known as export earnings
instability, which has been shown to lead to lower and less predictable rates of economic
growth. But, If the demand for exports is elastic, then a change in the average price of exports
will lead to a greater proportional change in the demand for them. This would be favorable to
a country where export prices were falling, since export demand would rise by proportionally
more than the prices fell leading to an increase in export revenue.
5.3. Terms of trade
Economists have a special name for the relationship or ratio between the price of a typical
unit of exports and the price of a typical unit of imports. This relationship is called the
commodity terms of trade, and it is expressed as Px/Pm, where Px and Pm represent the
export and import price indexes. The commodity terms of trade are said to deteriorate for a
country if Px/Pm falls, that is, if export prices decline relative to import prices, even though
both may rise. The main theory for the declining commodity terms of trade is known as the
Prebisch-Singer hypothesis.
5.4. The trade policy debate: Export promotion industrialization versus Import
substitution Industrialization
Two basic strategies regarding trade have been adopted through history: Import substitution:
Replacement of imported goods by goods produced domestically; via protection of domestic
markets against imports. Outward-looking trade policies (export-oriented strategies): Shift
focus from production for domestic markets to production for export to foreign markets; via
policies trying to promote and support exports.
Import substitution
The basic idea is the following: There may be high initial costs of local production. So, in
order to make it profitable for local entrepreneurs to invest, protective barriers are raised to
reduce the influx of imports. This increases the market for potential local producers and
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increases their profitability. How are these protective ―barriers‖ erected? The government
uses instruments that it has available. These usually include tariffs or quotas on imports,
sometimes ban on imports of certain goods, subsidies to the inputs of the local producers.
This idea that industries should be protected in the first stages of their development is called
the ―Infant Industry‖ argument, and it‘s associated with German economist Friedrich Liszt.
New industry in a country has to compete against firms abroad, which have long experience
with the same production technology, with marketing strategies, distribution channels, etc. So
these new national industries needs time to ―learn‖ the best way to operate on all these
dimensions.
Trade Policy Instruments
Protective Tariffs
A protective tariff works like a tax on imported goods: if you‘re an importer, you have to pay
a fraction of the imported good price as a tax to the government. The basic effect of a tariff is
to raise the domestic price above the world price. The tariff will increase domestic producer‘s
welfare because it‘ll allow them to sell more at a higher price. It will reduce domestic
consumers‘ welfare because they‘ll consume less at a higher price.
Import Quotas: Quotas are quantitative restrictions: the government fixes the maximum
quantity of a good that can be imported. Subsidies: Governments can offer subsidies to
domestic firms in order to increase their profitability and, therefore, ―protect‖ national firms.
Exchange Rate Management: Governments sometimes try to control the exchange rate to
affect the relative prices of tradable and, therefore, affect amount of imports and exports.
Outward-Looking Strategies
Shift the focus from import substitution and domestic markets towards manufacturing for
exports to foreign markets. In this strategy, tariffs and quotas should be reduced to a
minimum, and prices should move closer to world prices. Also, governments should set up
institutions to help promote exports: duty exemption systems, export processing zones,
infrastructure development (ports, roads, energy supply), export subsidies, etc.
Advantages:
Economies of scale and specialization: By concentrating on export markets, scale of
operation can be larger (not restricted to domestic market) take advantage of gains from
learning by doing and allows industry to overcome fixed costs. Foreign exchange: Exports
generate foreign exchange that may be necessary to pay for imports of raw material and
capital goods (great limitation in the import substitution strategy). Enhanced capacity to
import capital goods + exposure to competition from world markets generates conditions and
incentives for domestic firms to keep up with technological advances in the rest of the world

Necessary conditions for a successful exports-oriented strategy:

1st: Macroeconomic stability: A stable economic environment, with moderate inflation and
stable exchange rate (at market-determined level); economic policy making not strongly
affected by political interests, rent-seeking, or corruption
2nd: Infrastructure: Development of adequate infrastructure (roads, railways, ports, energy
supply, and telecommunications.

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3rd: Educated labor force: Development of adequate education and training institutions, in
order to provide workforce the relevant set of skills.
4th: Access of exporters to capital goods and raw materials at world prices: This can be
achieved via an open economy (no tariffs or quotas); or via Export Processing Zones (EPZ‘s),
which are areas where exporters have access to duty-free imports of capital and raw
materials, and adequate infrastructure (duty exemption systems do a similar job, but are not
geographically defined)
5th: Flexible factor markets: Well-functioning labor and capital markets, where labor and
capital can move freely, and their prices are not controlled.
5.5. Balance of Payments and Macroeconomic Stabilization
Balance of payments (BOP) accounts are an accounting record of all monetary transactions
between a country and the rest of the world. These transactions include payments for the
country's exports and imports of goods & services, financial capital, and financial transfers. A
country has to deal with other countries in respect of 3 items:- Visible items which include all
types of physical goods exported and imported. Invisible items which include all those
services whose export and import are not visible. e.g. transport services, medical services etc.
Capital transfers which are concerned with capital receipts and capital payment.
Components of BOP
1. Current Account Balance: BOP on current account is a statement of actual receipts and
payments in short period. It includes the value of export and imports of both visible and
invisible goods. There can be either surplus or deficit in current account. The current
account includes:- export & import of services, interests, profits, dividends and
unilateral receipts/payments from/to abroad.
2. Capital Account Balance: It is difference between the receipts and payments on
account of capital account. It refers to all financial transactions. The capital account
involves inflows and outflows relating to investments, short term borrowings/lending,
and medium term to long term borrowing/lending. There can be surplus or deficit in
capital account. It includes: - private foreign loan flow, movement in banking capital,
official capital transactions, reserves, gold movement etc.
3. Overall BOP: Total of a country‘s current and capital account is reflected in overall
Balance of payments.
Causes of Disequilibrium
Natural causes – e.g. floods, earthquake etc.; Economic causes – e.g. Cyclical Fluctuations,
Inflation, Demonstration Effect etc; Political causes – e.g. international relation, political
instability, etc and Social factors – e.g. change in taste and preferences etc.
Macroeconomic Stabilization
How to correct the Balance of Payment?
1. Monetary measures
⇒ Exchange Depreciation - Exchange depreciation means decline in the rate of exchange of
domestic currency in terms of foreign currency.
⇒ Devaluation - Devaluation refers to deliberate attempt made by monetary authorities to
bring down the value of home currency against foreign currency.
2. Non-Monetary Measures

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⇒ Export Promotion: The government can adopt export promotion measures to correct
disequilibrium in the balance of payments. This includes tax concessions to exporters,
marketing facilities, credit and incentives to exporters, etc.
⇒ Quotas: Under the quota system, the government may fix and permit the maximum
quantity or value of a commodity to be imported during a given period.
⇒ Tariffs: Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices
of imports would increase to the extent of tariff.
CHAPTER SIX
Foreign Aid, Debt, Financial Reform and Development
Foreign aid can be defined as the international transfer of public funds in the form of loans or
grants either directly from one government to another (bilateral assistance) or indirectly
through the vehicle of a multilateral assistance agency such as the World Bank. However, we
should not include all transfers of capital to developing countries, particularly the capital
flows of private foreign investors. Private flows represent normal commercial transactions,
prompted by commercial considerations of profits and rates of return, and therefore should
not be viewed as foreign aid. Commercial flows of private capital are not a form of foreign
assistance, even though they may benefit the developing country in which they take place.
Economists have defined foreign aid as any flow of capital to a developing country that meets
two criteria: 1. Its objective should be non-commercial from the point of view of the donor,
and 2 It should be characterized by concessional terms; that is, the interest rate and repayment
period for borrowed capital should be softer (less stringent) than commercial terms.
Concessional terms: terms for the extension of credit that is more favorable to the borrower
than those available through standard financial markets. Donor-country governments give aid
because it is in their political, strategic, or economic self-interest to do so. Some development
assistance may be motivated by moral and humanitarian desires to assist the less fortunate
(emergency food relief and medical programs). We focus here on the foreign-aid motivations
of donor nations in two broad but often interrelated categories: political and economic.
Economic
⇒ Assist with economic development and technology transfer ⇒ help in case of emergency
(e.g., natural disasters)
⇒ saving gap: The excess of domestic investment opportunities over domestic savings,
causing investments to be limited by the available foreign exchange i.e. causing economic
growth. So, external assistance is also assumed to facilitate and accelerate the process of
development by generating additional domestic savings as a result of the higher growth rates
that it is presumed to induce.
⇒ Foreign-exchange gap: The shortfall that results when the planned trade deficit exceeds the
value of capital inflows, causing output growth to be limited by the available foreign
exchange for capital goods imports i.e. aid improving the BOP.
⇒ Technology gap: facilitating industrialization given absorptive capacity limitation
⇒ Technical assistance: Financial assistance needs to be supplemented by technical
assistance in the form of high-level worker transfers to ensure that aid funds are used most
efficiently to generate economic growth.
Political
⇒ Use of aid to support regimes considered to be ‗friendly‘ to the interests of the donor
governments
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⇒ Promote ―national security‖ by shifting FA from one country or region to another
Humanitarian and moral motives
⇒ Short term emergency assistance
⇒ Long-term development assistance on debt relief and poverty alleviation
Factors limiting the effectiveness of aid
1. Tied aid
⇒ Tied aid. In the context of bilateral aid: recipients must spend part of the borrowed funds
on good and service from the donor country. Higher import costs and Purchase of
inappropriate capital intensive technologies and development and use of skills inappropriate
to local developing country conditions
2. Conditional aid
Conditional aid: Donors impose conditions to be met by recipients to ensure that funds are
used effectively. Policies towards market orientation, acceptance of projects decided by
donors, and detailed reporting on spending, timetables, and priorities.
Problems with conditional aid: The preferences of the government or population group are
not considered. Policy prescriptions by donors may be incorrect: May not fit in with the
government‘s priorities and May undermine government‘s authority.
3. Aid volatility and unpredictability: Makes it difficult for recipient governments to
implement policies that depend on aid funds
4. Uncoordinated donors: Uncoordinated donors and inefficiencies in the use of aid resources
5. Aid substitutes rather than complements domestic resources
Aid substitutes rather than complements domestic resources and no enough effort to increase
revenues through taxation.
6. Aid may not reach those most in need. Aid resources are not allocated on the basis of the
greatest need for poverty alleviation:
Bilateral donors guided by political and strategic interests. Recipient country‘s gov may not
be committed to poverty alleviation or lack expertise to design a poverty alleviation strategy.
7. Aid associated with corruption
⇒ Misuse of aid funds by recipient countries

Foreign debt may be defined as the amount of money that a country‘s residents, both public
and private, owe to the rest of the world. It is important to distinguish between gross and net
foreign debt. Gross foreign debt is the total amount borrowed from non-residents. Net foreign
debt is gross foreign debt minus resident‘s lending to overseas. Many people view foreign
debt as a disadvantage for a country, although most countries do have a foreign debt.
However, foreign debt can be an advantage since it can provide an increase in a nation‘s
productive capacity, output, employment and living standards.
A serious problem can arise, however, when;
1 The accumulated debt becomes very large.
2 The sources of foreign capital switch from long-term ―official flows‖ on fixed, concessional
terms to short-term and at higher interest rate.
3 The country begins to experience severe balance of payments problems.
4 A global recession or some other external shock.
5 A loss in confidence in the ability of a developing country to repay.
6 A substantial flight of capital is precipitated by local residents.
DEBT SERVICING
Repaying foreign debt requires payment of the original sum borrowed, plus interest on that
debt. This is known as debt servicing.
Foreign debt can be seen as: A nation‘s imports and income paid to overseas residents is
greater than the value of exports and income received. National expenditure exceeding
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national income, i.e. a nation spending more than it earns. The difference between national
investment and national savings: If a country does not have sufficient domestic savings, it
must borrow to finance its investment which must come from overseas.
CONSEQUENCES OF FOREIGN DEBT
Foreign debt has several consequences for a country: 1 Falling credit ratings – this will
increase the interest rate that the country will have to pay on future borrowings since lenders
perceive a greater lending risk. 2 The increased interest payments lower the country‘s
standard of living as more income is diverted from consumption
REDUCING FOREIGN DEBT
There are several ways to reduce a country‘s foreign debt:
i) Increasing international competitiveness (microeconomic reform). Growth in exports will
reduce the CAD and hence foreign debt. ii) Increasing the savings pool - this will reduce the
borrowings required to fund investment iii) Monetary policy to maintain low inflation rates
will improve export competitiveness – this will also preserve the real purchasing power of
savings and will act to improve the level of domestic savings. iv) Use of fiscal and monetary
policy to reduce aggregate demand-this will discourage import demand which contributes to
foreign debt.

There are two main types of foreign investments: Portfolio investment and direct investments
Portfolio investments are purely financial assets, such as bonds and stocks, denominated and
expressed in a national currency. They take place primarily through financial institutions
(banks and investment funds).
Direct investments are real investments in factories, capital goods, land, and inventories
where both capital and management are involved and the investor retains control over use of
the invested capital.
FDI Debate: Pros
⇒ Foreign Direct Investment fills the
1 Saving gap: causing economic growth
2 Foreign-exchange gap: improving the BOP
3 Tax revenue gap: raising funds for public spending
4 Management gap: improving entrepreneurship
5 Technology gap: facilitating industrialization
FDI Debate: Cons
⇒ Multi-National Corporations
Don‘t reinvest their profit
 Return profits to their headquarters through transfer pricing
 Create income for semi-skilled labor with low saving propensities
 Deteriorate current account through importation of capital goods and intermediate
products
 Deteriorate capital account through outflow of profits
 Receive investment tax credits and are exempt from tariffs
 Hinder development of domestic managerial skills
 Gain monopoly power
 Reinforce dualism, increase income inequality, and induce R-U migration Influence local
politics and support ―friendly‖ governments

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 International economics I
CHARACTERISTIC FEATURES OF INTERNATIONAL TRADE

Meaning, Nature, and Scope of International Economics

International Economics as a distinct branch of Economics International economics is a
subfield within economics which concerns itself with the economic activities of different
countries around the world and its global effects. In other words, international economics is a
field concerned with economic interactions of countries and effect of international issues on
the world economic activity. Over the years, the field of international economics has
developed drastically with various theoretical, empirical, and descriptive contributions
making it a distinct branch of Economics. As International economic relations differ from
interregional economic relations (i.e., the economic relations among different parts of the
same nation), international economics requires somewhat different tools of analysis. The
following arguments justify international economics as a distinct branch of economics.
Nations usually impose some restrictions on the flow of goods, services, and factors across
their borders, but not internally.
International flows are to some extent hampered by differences in language, customs, and
laws.
International flows of goods, services, and resources give rise to payments and receipts in
foreign currencies, which change in value over time.
The impact of various government restrictions on production, trade, consumption, and
distribution of income are covered in the study of international economics. Thus, it is
important to study the international economics as a special field of economics.
Normally, factors of production are mobile within a country but are not as mobile
internationally.
However, with the advent of globalization, international mobility of factors of production has
become much easier which in turn affects the comparative advantage of nations. Under such
economic reality, it requires the theoretical concepts and tools of international Economics to
understand what impact the increasing mobility of the factors of production has on
comparative advantage.
Nature and scopes of international economics
The Subject Matter of International Economics that comes under its scope deals with the
economic and financial interdependence among nations. The scope of international
economics is wide as it involves various concepts, issues and theories. Nature and Scope of
international Economics can be studied as below:
1. International trade policy examines the reasons for and the effects of trade restrictions.
Theoretical international economics is grouped into two categories as: (i) Pure Theory of
International Economics: The pure theory of international economics deals with trade
patterns, impact of trade on production, rate of consumption, and income distribution. It
involves microeconomic part of international economics.
2. Monetary Theory of International Economics: The monetary theory of international
economics is concerned with issues related to balance of payments and international
monetary system. It involves macroeconomic part of international economics. 2.
Descriptive International Economics: Descriptive International Economics deals with
institutional environment in which international transactions take place between
countries. Descriptive international economics also studies issues related to international
flow of goods and services and financial and other resources. 3. International finance or
open-economy macroeconomics: International Economics deals with international

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 finance which studies how capital flows between international by applying
macroeconomic principles. Areas that fall within the remit of international finance are:
a) Balance of payments: The balance of payments measures a nation‘s total receipts
from and the total payments to the rest of the world.
b) Foreign exchange markets: Foreign exchange markets are the institutional framework
for the exchange of one national currency for others.
3. International trade policy: International trade policy examines the reasons for and the
effects of trade restrictions. The impact of various government restrictions on production,
trade, consumption, and distribution of income are covered in the study of international
economics.
4. International economic institutions: International Economics studies the functioning of
various emerging international economic institutions, such as World Trade Organization
(WTO), International Monetary Fund (IMF), United Nations Conference on Trade
Development (UNCTAD) and World Bank
5. Globalization: With the advent of globalization, there is a rapid increase in the free flow
of goods and services, capital, labor and finance between nations. Globalization has led to
increase in employment opportunities, International Competition and standardization of
international economic laws and policies. Thus, the advent of globalization has widened
the field of International Economics.

Basis of International Trade

The following points explain why nations trade with each other.
i. Differences in factor endowments
Nature has distributed the factors of production unequally over the surface of the earth.
Countries differ in terms of natural resource endowments, climatic conditions, mineral
resources and mines, labor, capital, technological capabilities, entrepreneurial and
management skills, and other variables that determine the capacities of countries to produce
goods and services. All these differences in production possibilities lead to situations where
some countries can produce some goods and services more efficiently than others; and no
country can produce all the goods and services in the most efficient manner ( at the lowest
possible cost of production).
ii. Division of labor (specialization)
Just as there is division of labor among individuals, there could be division of labor among
countries of the world. No individual is able to produce all the goods and services that he/she
requires to consume and this applies to countries as well. Just as individuals specialize in
certain functions, countries specialize in the production of certain goods and services in
which they have production superiorities over the other countries. Thus, a country specializes
in the production and export of those goods and services over which they have absolute or
comparative advantage; and it imports other goods and services in the production of which it
has an absolute or a comparative disadvantage over the other countries of the world.
iii. Gains form exchange of goods and services
The basis of international trade is the gains or profits to be made from the exchange of goods
and services. If there are no gains to be made, there would be no such trade between
countries.
iv. Price differentials
The immediate cause of international trade is the existence of differences in the prices of
goods and services between nations. Foreigners buy our goods because they find them
cheaper than anywhere else in the world; and we buy foreign goods because we find them
cheaper. Price differences can arise due to either differences in supply conditions or
differences in demand conditions or due to differences in both.
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a) differences in supply conditions (or production possibilities)
Such differences can arise due to several factors that determine the cost of producing goods
and services. These factors include natural endowments of economic resources, the degree of
efficiency with which these factors are employed, the level of technology used in production,
labor skills, factor abundance, etc.
b) differences in demand conditions
Differences in demand conditions, which are largely a function of income levels and taste
patterns, contribute to international price differentials. Countries A and B may be producing
the same commodity at the same cost of production, but that does not guarantee the same
price in both countries for that commodity.
This is due to:
 Differences in supply conditions, where supply curve of the home country is less elastic than
the supply curve of the home country.
 Differences in demand condition, where the demand curve of the home country is more
elastic than the demand curve of the foreign country.
differences in both demand and supply conditions, where demand curve of the home country
is more elastic than the demand curve of the foreign country, but the supply curve of the
home country is less
CHAPTER TWO INTERNATIONAL TRADE THEORIES
2.1. Pre- Classical theory of International Trade (Mercantilism)
The economic philosophy that prevailed during the 17th and 18th centuries was that of the
Mercantilism. The main feature of the mercantilist doctrine was that a country could grow
rich and prosperous by acquiring more and more precious metals especially gold, and,
therefore, all the efforts of the state should be directed to such economic activities that help a
country to acquire more and more precious metals. According to the mercantilist school of
economists, if international trade is not properly regulated then people might exchange gold
for commodities of daily use or require for a luxurious living. This would lead to the
depletion of the stock of precious metals within the nation. Thus, exports were viewed
favorably so long as they brought in gold but imports were looked at with apprehension as
depriving the country of its true source of riches, i.e., precious metals.
Taxing imports was often justified as a way of creating jobs and income for the national
population. Imports were supposed to be bad because they had to be paid for, which might
cause the nation to lose spices (gold or silver) to foreigners if it imported a greater value of
goods and services than it sold to foreigners. Imports were also to be feared because those
same foreign goods might not be available in time of war demonstration.

The Classical and Neoclassical Trade Theory

Presently, opinions vary amongst economists regarding the contributions of the classical
economists to economics as a special discipline. The universal belief, however, is that the
classical economists has left us with a rich and useful legacy. Three broad questions were
asked to define the framework in which the classical economists explained the implications
of foreign trade. These are: 1. what is the basis of trade and what good does a country export
and import? 2. On what terms are the traded goods being exchanged? 3. If disturbances occur
in trade pattern, what forces bring about adjustment and how will they do it?
The answers to these three questions evolved several hundred years ago. They incorporated
the intellectual efforts of such economists as Adam Smith, David Ricardo, John Stuart Mill
and many others. The collective body of thought that was formed by these scholars later came
to known as a general theory of international trade. Modern economists, however, have found
it necessary to treat the various aspects of international trade separately, and to distinguish

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between pure trade theory and the monetary (balance of payments) theory. The pure trade
theory has to do with the more fundamental questions that concern the basis for, and gains so
be derived from foreign trade.
Smith’s theory of Absolute Advantage and Ricardo’s theory of Comparative Advantage
Smith‘s Theory of Absolute Advantage By absolute advantage, we mean the ability of a
country to produce a specific good with fewer resources than other countries (Meier, 1988).
To illustrate this, we look at the example in which Nigeria and South Africa are both
producing crude oil and diamond. Each country can produce the following units of crude oil
and diamond with the dame amount of labour as shown below.
Cost of producing a given output
Countries Labour Input Crude Oil Output Diamond Output
Nigeria 1000 units 300 150
South Africa 1000 units 200 400
When we compare the figures in the table above, we see that using the amount of labour,
Nigeria can produce more units of crude oil than South Africa. In the production of crude oil,
Nigeria has an absolute advantage over South Africa. Specifically, Nigeria uses fewer
resources to produce more unit of crude oil. Similarly, South Africa has an absolute
advantage over Nigeria in the production of diamonds because she uses fewer unit of labour
to produce more units of diamonds. Thus, it follows that if two countries trade with each
other, Nigeria will benefit by specializing in crude oil production. She will then export her
surplus crude oil to finance diamonds imports from South Africa. South Africa will benefit
by specializing in diamond production and exporting her excess diamond to finance. crude oil
imports from Nigeria. From this analysis, we have seen that, as a result of international
division of labour, a country can consume a commodity that she cannot produce.
Ricardo’s Theory of Comparative Advantage
The theory states that a country will gain from trade if she specializes in the production of a
specific commodity in which she uses a lower opportunity cost than her trading partner. That
is, a country should specialize in the production of those commodities which makes the most
efficient use of its scarce resources (for which the opportunity cost is the lowest). In
illustrating the meaning of comparative advantage, Ricardo used a simple example of two
countries, two commodities and one factor of production (labour), 2 x 2 x 1 model as shown
below.
Comparative Advantage Illustration
Amount of Labour required to produce a given output
Countries Wine Cloth Diamond Output
France 1000 untis 80 90
Ghana 1000 units 120 100
As can be seen from the table above, France has an absolute advantage over Ghana in the
production of both commodities. However, she has a comparative advantage in the
production of wine than Ghana. That is she produces 1 unit of wine with 67% of her
resources. That is =67% but the production of cloth it will take France 90% of her
resources. That is to produce one unit of cloth. The table also shows that
Ghana has absolute disadvantage in both commodities. But she has a comparative
disadvantage in the production of wine. Specifically, 150% of Ghana‘s resources are devoted
to produce one unit of wine that is because Ghana‘s comparative
disadvantage is greater in wine production than in cloth. She used only 111% of her resources
to produce one unit of cloth. This is because

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It is important to state that if all countries specialize according to such comparative cost
advantages, the least amount of resources will be utilized in the most efficient manner and
output will be greater.
The Neoclassical Trade Theory Some classical economists recognized that some of their
assumptions served to favors free trade. For example, Mill as well as Ricardo admitted that
the assumption about international mobility of labour and capital was unrealistic. But since
this assumption was indispensable to the classical case, Mill hit upon a compromise. For the
purpose of analysis, he defined international trade as the exchange of goods by areas among
which productive resources cannot be moved easily. This definition still underlines the
modern trade theory.
A serious defect of the classical analysis is found in two other assumptions namely: 1. Labour
was considered as the only factor of production 2. The value of goods is derived from their
labour content. These assumptions were an integral part of the labour theory of value, which
as we have seen, played a major role in the classical economic
Modern International Trade Theory
There are many international trade theories, from country-based or classical trade theories to
modern theories that focus on the firm rather than the country. However, the historical
theories of each country are just as important as modern theories; they explain how nations
expanded around the globe and built their wealth through trade.
On the other hand, modern theories are useful and can help with international trade. They can
help a business determine the right country to expand into and make goods more efficiently
than other firms. These theories incorporate more factors than country-based theories.
Determining Country Similarity
The Country Similarity Theory was developed by Steffan Linder to explain the idea of
intra-industry trade. Linder proposed that consumers in countries with similar stages of
development will have the same, or similar, preferences for domestic consumption. To
determine the similarity of countries, the Geert-Hofstede model is another tool that was
developed to compare countries. This model uses six dimensions to compare countries:
1) Power Distance - is power in the country distributed unequally?
2) Individualism - the degree of interdependence of the members of a society.
3) Masculinity - wanting to be the best versus liking what you do (Feminine).
4) Uncertainty Avoidance - are members of a society feeling threatened by unknown
situations?
5) Long Term Orientation - society has links with the past and deals with the challenges of
the present and the future.
6) Indulgence - do members of a society control their impulses and desires?
Both of these theories are useful in understanding trade where product reputation and brand
names are key factors in the consumer's decision-making and buying processes.
Product Life-Cycle Theory
Back in the 1960s, Raymond Vernon developed the product life-cycle theory to explain the
manufacturing success in America. This theory states that a product life cycle has three
stages:
1) New Product
2) Maturing Product
3) Standardized Product
This theory assumed the product progresses through these stages, and the production will
happen in the country it was invented. However, this theory doesn't explain current
international trade patterns when it comes to manufacturing and innovation around the world.
New trade theory (NTT) is a collection of economic models in international trade theory
which focuses on the role of increasing returns to scale and network effects, which were
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originally developed in the late 1970s and early 1980s. The main motivation for the
development of NTT was that, contrary to what traditional trade models (or "old trade
theory") would suggest, the majority of the world trade takes place between countries that are
similar in terms of development, structure, and factor endowments.
CHAPTER THREE INTERNATIONAL TRADE POLICY
3.1.The Instruments of Trade Policy
Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export
restraints, local content requirements, administrative policies and antidumping duties.
Specific tariffs: are levied as a fixed charge for each unit of a good imported
a tariff is a tax levied on imports or exports. They are divided in two categories:
Ad valorem tariffs: are levied as a proportion of the value of the imported good
in most cases, tariffs are placed on imports to protect domestic producers; tariffs increases
government revenues.
A subsidy is a government payment to a domestic producer. They take many forms like, cash
grants, low-interest loans, tax breaks and government equity participation in domestic firms.
Subsidies help domestic producers in two ways: (1) competing against foreign imports and
(2) gaining export markets.
An import quota is a direct restriction on the quantity of some good that maybe imported
into a country. The restriction is usually enforced by issuing import licenses to a group of
individuals or firms
a voluntary export restraint is a quota on trade imposed by the exporting country, typically
at the request of the importing country‘s government.
A local content requirement is a requirement that some specific fraction of a good needs to
be produce domestically.
Administrative trade policies are bureaucratic rules designed to make it difficult for imports
to enter a country.
Anti-dumping duties, dumping are a variously defined as selling goods in a foreign market
at below their costs of producing; dumping is viewed as a method by which firms unload
excess production in foreign markets. Antidumping policies are designed to punish foreign
firms that engage in dumping. Their objective is to protect domestic producers from unfair
foreign competition.

Arguments against protection

1. Vested interests are created
Once certain industries are given protection, they claim it as a matter of right. It then becomes
very difficult to take away protection. The infants begin kicking if you touch them in any
manner. Such infants refuse to admit that they have grown into adults.
2. Protection produces lethargy and acts like an opiate
When foreign competition has been removed, it sends the home manufacturers to sleep, as it
were. They do not try to make any improvement, and technical progress comes to a standstill.
3. Then there is the danger of corruption
The industrialists bribe legislators so that protection is not taken away. This evil was rampant
in the U.S.A. at one time.
4. Protection creates monopolies
Tariff is said to be the mother of trusts. When foreign competition has been removed, the
home manufacturers are tempted to combine to reap monopoly profits.
5. Consumers and unprotected industries suffer
This is so because imposition of import duties invariably leads to the rising of prices.
6. The distribution of wealth becomes more unequal
Protection favors the rich capitalists who grow still richer. The gulf between the 'haves'
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and 'have-nots' is thus widened still further.
7. Source of conflict
Protection leads to conflict, friction and retaliation in international dealings. It thus
breeds the germs of future wars.
8. Inefficiency in world resource allocation
The most important argument against protection on economic grounds is that it militates
against optimum utilization of resources. It hampers international division of labor so that
labor, capital and other factors of production do not find their most remunerative
employment. Their distribution is not governed by natural economic forces-, but they are
artificially forced into certain channels.
1) Non-discriminatory tariffs: uniform tariffs rates imposed on goods and services
regardless of their source of origin or destination. Tariffs are said to be single column
when they are non- discriminatory and double-column when they are discriminatory.
2) Revenue tariffs: these are tariffs that are imposed primarily and produce revenue for the
government
3) Protective tariffs: are tariffs that are imposed primarily to protect the domestic
industries from foreign competitions
4) Retaliatory tariffs: when country A imposes (increases) duties against the products
from country B, it is possible that country B will retaliate and levy duties on goods
imported from country A. Thus, country B‘s tariffs are then described as retaliatory
tariffs.
5) Countervailing tariffs: Tariffs are said to be countervailing when a country imposes
(increases) import duties with a view to offset export subsiding in the country of origin.

Trade Policy and Economic Welfare

Economists agree that economic growth is potentially the most important channel to reduce
poverty and that international trade might play an important role in this process. This
argument requires one to first examine the relationship between international trade and
economic growth, and then consider how trade-induced economic growth might affect
poverty. Theoretically, the relationship between international trade and growth is ambiguous,
especially for lower-income countries that might not have comparative advantage in sectors
that generate dynamic gains from trade (Rodriguez and Rodrik, 2001). International trade
raises average incomes through static gains from trade due to specialization according to
comparative advantage and economies of scale, among other factors.

Optimal Trade Policy Intervention

The theory of international trade has been transformed in recent decades, moving study away
from the stylised world of perfect markets to a much richer recognition of imperfections of all
sorts. Frictions to international trade and investment flows do not arise just because of tariff
barriers, but are also due to geography, institutions, and information barriers. Markets are not
all perfectly competitive but instead contain firms with market power, as well as
imperfections in labour and capital markets. Production often involves increasing returns to
scale, this requiring that focus be put on firms, rather than just the sectors of activity studied
in competitive trade theory. Attention on firms has allowed the theory of foreign direct
investment to be brought into the mainstream of trade theory. Dynamics and the processes of
technology development and transfer have been analyzed.
4. INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT

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 4.1 Contributions of Trade to Development
Haberler has pointed out the following important beneficial effects that international
trade can have on economic development:
(1) Trade can lead to the full utilization of otherwise underemployed domestic resources. That
is, through trade a developing nation can move from an inefficient production point inside
its production frontier, with unutilized resources because of insufficient internal demand, to a
point on its production frontier with trade. For such nation, trade would represent a vent for
surplus, or an outlet for its potential surplus of agricultural commodities and raw materials.
This has indeed occurred in many developing nations, particularly those in South East Asia
and West Africa.
(2) By expanding the size of the market, trade makes possible division of labor
and economies of scale. This is important has actually taken place in the production of light
manufactures in small economies such as Taiwan, Hong Kong and Singapore.
(3) International trade is the vehicle for the transmission of
new ideas, new technology, and new managerial and other skills.
Trade also stimulates and facilitates the international flow of capital from developed to
developing nations.
4. In case of foreign direct investments, where the foreign firm retains managerial control
over its investment, the foreign capital is likely to be accompanied by foreign
skilled personnel to operate it.
(5) In several large developing nations, such as Brazil and India, the importation of
new manufactured products has stimulated domestic demand until efficient
domestic production of these goods become feasible.
(6) International trade is an excellent antimonopoly weapon because it stimulates greater
efficiency by domestic producers to meet foreign competition. This is particularly important
to keep low the cost and price of intermediate or semi-finished products used as inputs in
the domestic production of other commodities.
4.2. Beneficial Effects of Trade

 Trading globally gives consumers and countries the opportunity to be exposed to goods
and services not available in their own countries or more expensive domestically.
 The importance of international trade was recognized early on by political economists
such as Adam Smith and David Ricardo.

 Still, some argue that international trade can actually be bad for smaller nations,
putting them at a greater disadvantage on the world stage.
Countries trade with each other because they derive essential benefits. Trading benefits
include:

1. Lower prices for consumers

2. Greater choice for consumers
3. Wider market size for the company
4. Higher economies of scale
5. More intense competition
6. Greater efficiency in production
7. Obtaining the required resources
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8. More efficient resource allocation
9. Source of foreign exchange reserves
10. Skills and technology transfer
11. A key driver for economic growth

4.3. Static versus Dynamic Analysis in Trade

Dynamic economics also studies the process by which equilibrium is achieved. As a result,
there may be equilibrium or may be disequilibrium. Therefore, static analysis is a study of
equilibrium only whereas dynamic analysis studies both equilibrium and disequilibrium.

4.4. Alternative Trade Strategies

 Price-Momentum
The price-momentum strategy is based on buying the best-performing stocks and selling the
worst-performing stocks, according to a predefined criterion. The performance criterion can
be cumulative return, mean return, or risk-adjusted return. The strategy can be long-only –
you open long positions in the top 10% of the best-performing stocks, or long-short, where
you buy the top 10% best performing and sell short the 10% of the worst-performing stocks.
 Earnings-Momentum
The earnings-momentum strategy follows the same logic as the price-momentum strategy
above – buying or selling the top/bottom 10% stocks according to their performance. What is
different is the performance criteria. In the price-momentum strategy, the performance
criterion is return, while in the earnings-momentum strategy the criterion is based on
earnings.
 Book-To-Price Value
This strategy is also based on buying the top winners and selling the bottom losers, like the
price-momentum and the earnings-momentum strategies above. The difference is that the
performance selection criterion is based on book-to-price value (B/P ratio). The portfolio in
this strategy consists of buying the top 10% stocks with the highest B/P ratio and selling short
the bottom 10% with the lowest B/P ratio.
 Low-Volatility Anomaly
The low-volatility anomaly trading strategy relies on the observation that the future returns of
low-return-volatility portfolios outperform the returns of high-return-volatility portfolios.
While this is counter intuitive because the general notion that higher risk yields higher returns
the low-volatility anomaly strategy shows quite good returns.
 Implied Volatility
The implied volatility strategy is based on an observation on the put/call implied volatility of
stock options. The observation suggests that stocks with the largest increases in call options
implied volatilities over the previous month on average tend to have higher future returns. On
the other side it of the observation, stocks with the largest increases in put options implied
volatilities over the previous month on average tend to have lower future returns. As a result,
the trader can open long positions in the stocks in the upper 10% according to these criteria
and short positions in the stocks in the lower 10%.
 Multifactor Portfolio
The multifactor strategy relies on buying and selling short stocks based on more than one
factor. The observed factors can be value, momentum, volatility, etc. As a result, a trader can
combine uncorrelated factors and extract additional value for the portfolio.
 Pairs Trading Strategies

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Pairs trading are a classic example of a mean-reversion strategy. The first step in the pairs
trading strategy is based on identifying a pair of stocks with highly correlated historical
performances. The next step of the strategy is to monitor how the correlation between the two
stocks changes over time. When mispricing is observed, the trader sells short the overpriced
stock and buys the underpriced stock.
 Single Moving Average
The single moving average is one of the very basic trading strategies. It is based on the price
of an asset (stock, futures contract, currency pair, etc.) crossing up or down a moving
average. The conditions in this system are quite basic. If the price crosses up a moving
average, the trader opens a long position. Vice-versa if the price crosses down a moving
average, the trader opens a short position. It can be run as long-only, short-only, or long-short
strategies in single or multi-asset setups.
 Moving Averages Crossover
The moving averages crossover is another very popular trading strategy. It relies on two
moving averages – a fast one (short period) and a slow one (long period). The trading logic of
the moving average crossover is very similar to the single moving average strategy. What is
different is that the trader is looking for a cross-over of the fast and the slow moving averages
instead of just the market price and a single moving average.
 Multiple Moving Averages Crossover
The multiple moving averages crossover strategy adds additional moving averages with
different durations in addition to the fast and the slow moving averages in the strategy above.
The additional indicators can be used to filter false signals. For example, instead of opening a
long position when the fast-moving average crosses above the slow one, the trader waits for a
third moving average also to cross before opening his position.
 Pivot Points Support and Resistance
The pivot points support, and resistance strategy is based on the pivot points trading
indicator. This popular indicator has three basic levels – center, support, and resistance. The
center level is calculated as the average of the previous day‘s high, low, and close prices. The
resistance level is calculated as two times the center level minus the previous day‘s low. The
support level is calculated as two times the center level minus the previous day‘s high. In the
strategy, the trader opens a long position when the market price crosses the central level
upwards and liquidates it when it reaches the resistance level. The short position trigger
signal is when the market price crosses the center level downwards and the target is hit when
the support level is reached.
 Channel Trading Strategies
There are several trading indicators that consist of channels, with the most popular being
Donchian channel, Bollinger bands, and Keltner channel. The concept of a channel trading
strategy is to buy or sell short an asset when it reaches the bottom or the upper level of a
channel. A channel consists of two lines forming a band with the price fluctuates. There are
two signal conditions in channels trading – the price would bounce back from a channel, so
the trader would expect it to remain in the channel or the price would break through the
channel which signals the emergence of a new trend.
 Merger Arbitrage
Merger arbitrage or also known as risk arbitrage is a trading strategy aiming to capture an
excess return that is occurring due to corporate actions such as mergers and acquisitions. You
can find a merger arbitrage opportunity whenever one publicly traded company is trying to
acquire another public company at a price that is different from the current market price.
There are two types of mergers – cash and stock merger. The strategy in the case of a cash
merger is to establish a long position in the target company stock. In the case of a cash

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merger, the strategy is to establish a long position in the target company stock and a short
position in the acquiring company stock.
 Market Making
The market making strategy is one of the most popular ones in algorithmic and quantitative
trading. It is as simple as capturing the bid-ask spread for a given trading instrument – you
buy at the bid and sell at the ask. However, like many things in life there is much more than
that. It relies on the fact that most of the order flow on the market is ―dumb‖ money
(uninformed retail investors). While it can work well in some markets, the strategy hits its
limits when it meets the ―smart‖ money (informed investors).
 Alpha Trading Strategies Generation
The alpha generation is a strategy where the traders are trying to gain an edge by data mining
and machine learning methods. An alfa is every trading strategy resulting from this
generation which has reasonable expected return. Quite frequently these alphas are weak and
cannot be traded on their own, so they are combined in a combination of alphas, also known
as ―alpha combo‖ strategy.
 Carry Trade
The carry trade is one of the most popular FX trading strategies. It is based on gaining from
the interest rate differentials between two currencies. In the carry trade strategy implies that
high interest rate currencies should lose value versus low interest rate currencies. In the basic
carry trade strategy, the trader sells short forwards on currencies that are quoted at a premium
(the forward FX rate exceeds the spot FX rate) and vice-versa. This strategy is not a risk-free
arbitrage, because there is a chance that the FX rate suddenly changes, and the trader is
exposed to exchange rate risk.
 Forex Triangular Arbitrage
The Forex triangular arbitrage is a trading strategy based on opening positions in 3 currency
pairs. For example, EURUSD, USDJPY, and EURJPY. The system is relying on catching
discrepancies (arbitrage opportunities) occurring by opposing positions where the rate of one
currency pair diverges from the cross rate between, the other two. For example, if the result
of exchanging EUR to USD is different than the result from exchanging EUR to JPY and JPY
to USD there is an arbitrage opportunity.
 Commodity Futures Contracts Roll Yields
Commodity futures contracts roll yields is a strategy that aims to gain from the natural
backwardation or contagion occurring between the different futures contracts‘ maturities.
Roll yields occur from rebalancing futures positions. When a futures contract is about to
expire, it needs to be replaced with another futures contract with longer expiration. If the
price of the front futures contract is higher than the following month futures price, there is
backwardation. If it is the opposite – the price of the front futures contract is lower than the
price of the following month futures price, then there is contagious.
 Calendar Spread
In commodity futures markets the near-month contracts react to supply and demand changed
quicker than further-month contracts most of the time. As a result, a trader can implement a
trading strategy, called calendar spread which aims to gain from the difference. There are two
types of calendar spread. The bull futures spread is based on buying a near-month futures
contract and selling the further-month contract. The bear futures spread is the opposite – you
sell the near-month contract and buy the further-month one.
 Convertible Arbitrage
The convertible arbitrage strategy is based on convertible bonds. A convertible bond is a
security with hybrid properties that gives the investor the option to convert the bond from a
fixed-income instrument to equity. This transformation happens according to a predefined
conversion ratio of bonds to stocks when the stock price reaches a certain level (called
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conversion price). The convertible arbitrage strategy is based on buying a convertible bond
and selling short the underlying stock.
 Sentiment Analysis
The sentiment analysis strategy is based on extracting trading signals using machine learning
algorithms applied to social media data. The process starts with the collection of social media
posts (most frequently tweets) that are containing at least one keyword listed in vocabulary
over a predefined time frame. The second step is cleaning the data. After this is completed the
data is further processed by the machine learning algorithms aiming to extract models that
can be used to predict the price movements according to the public sentiment

International Economics II
1.1. The Foreign Exchange Market, dear learner given money (currency)
It may also be sold by itself for yet another currency. This implies that there is market (a
place or an arrangement) in which currencies of different countries are purchased and sold.
That market is termed the foreign exchange market. The market consists of various groups
(individuals) of the society. This section presents a relative in-depth discussion of the foreign
exchange market. The foreign exchange market is the market in which individuals, firms, and
banks buy and sell foreign currencies or foreign exchange. The price of one currency in terms
of another is called an exchange rate.
1.2. Why do individuals, firms, and banks want to exchange one national currency
for another?
1.3. Functions of the Foreign Exchange Markets
The principal function of foreign exchange market is the transfer of funds from one nation
and currency to another. This is usually accomplished by Reuter‘s electronic trading system,
where all markets around the world are connected through a network. The role of commercial
banks as clearing house f or the foreign exchange demanded and supplied in the course of
foreign transactions by the nations residents.
1.4. Types of Foreign Exchange Transactions
The two-day period, known as immediate delivery, allows time for the two parties to forward
instructions to debit and credit bank accounts at home and abroad. In many cases, however, a
business or financial institution knows it will be receiving or paying an amount of foreign
currency on a specific date in the future.
Exchange Rate Determination
Exchange rate refers to the amount of the home country‗s currency has be afforded in order to
purchase another (foreign) currency. The important question is thus ―how can this rate
(price) be determined? If we assume a free market economy (and hence a flexible foreign
exchange rate system), the equilibrium exchange rate is determined by both demand and
supply situations of the foreign currency.
A. Supply of Foreign Exchange
The supply of foreign exchange for a given country results from transactions that appear on
the credit side of that country‗s BoPs. The supply of pounds, for instance, is generated by the
desire of UK residents and businesses to import Ethiopian goods and services, to lend funds
and make investments in Ethiopia, and to extend transfer payments to Ethiopian residents.
B. Demand for Foreign Exchange
A nation‗s demand for foreign exchange is derived from, or corresponds to, the debit items
on its balance of payments. For example, the Ethiopian demand for pounds may stem from its
desire to import British commodities, to make investments in Britain, or to make transfer
payments to residents in Britain! Like most demand schedules that you know, Ethiopian
demand for pounds varies inversely with its price.
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 C. Equilibrium Exchange Rate
As we highlighted earlier, the equilibrium exchange rate is determined by the market forces
of demand and supply but this really happens if the monetary authorities do not attempt to
stabilize exchange rates or moderate their movements. In other words, there must exist a
free market economy for the equilibrium price of foreign currencies to be fixed by their
supply and demand. As we highlighted earlier, the equilibrium exchange rate is determined
by the market forces of demand and supply but this really happens if the monetary authorities
do not attempt to stabilize exchange rates or moderate their movements.
1.5. Exchange Rate Regimes:-Spot and Forward Rates of Exchange markets? What are
spot and forward transactions?
As we said earlier, the most common type of foreign exchange transaction involves the
payment and receipt of the foreign exchange within two business days after the day the
transaction is agreed upon.
This type of transaction is called a spot transaction.
The exchange rate at which a spot transaction takes place is called the spot rate (SR). The
exchange rate R = Br/₤ = 13 in the above figure is thus a spot rate.
This type of transaction is called a spot transaction. The exchange rate at which a spot
transaction takes place is called the spot rate (SR). The exchange rate R = Br/₤ = 13 in the
above figure is thus a spot rate. On the other hand, we have forward transactions. These
involve an agreement today to buy or sell a specified amount of a foreign currency at a
specified future date at a rate agreed upon today (the forward rate, FR). The equilibrium
forward rate is determined at the intersection of the market demand and supply curves of
foreign exchange for future delivery.
If the forward rate is below the present spot rate, the foreign currency is said to be at a
forward discount (FD) with respect to the domestic currency.13.8.Percent annual discount)
with respect to the birr.
When the forward rate is above the present spot rate the foreign currency is at a forward
premium (FP) with respect to the domestic currency. For example, suppose the monthly
forward rate is still Br 8.60 = $1 but the spot rate is instead 8.55 birr per dollar. The dollar is
therefore said to be at a premium of 5 cents (= 8.60 - 8.55) or 0.6 percent (or at a 7 percent
forward premium per year) with respect to the Ethiopian currency.
Forward discounts and premiums are usually expressed as percentages per year from the
corresponding spot rate. They can be calculated formally with the following formula:

𝑁
2. THEORIES OF EXCHANGE RATE DETERMINATION
2.1. The Purchasing – Power Parity (PPP) Approach
Determining the long – run equilibrium value of an exchange rate (the value toward which
the actual rate tends to move, given current economic conditions and policies) is important
for successful exchange rate management. For example, if a nation‗s exchange rate rises
above the level warranted by economic conditions, so that its currency becomes overvalued,
the nation‗s costs will no longer be competitive and a trade deficit will likely occur. An
undervalued currency tends to lead to a trade surplus. National authorities try to forecast the
long–run equilibrium exchange rate and initiate exchange rate adjustments to keep the actual
rate in line with the forecast rate. The PPP, therefore, can be used to make predictions about
exchange rates.R0
2.2. The PPP theory and the Law of one price Relative PPP
According to the relative purchasing power–parity theory of exchange rate determination,
changes in relative national (general) price levels determine changes in exchange rates over
the long-run. The theory predicts that the foreign exchange value of a currency tends to
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appreciate or depreciate at a rate equal to the difference between foreign and domestic
inflation.
A currency would be expected to depreciate by an amount equal to the excess of domestic
inflation over foreign inflation. It would appreciate by an amount equal to the excess of
foreign inflation over domestic inflation.

Where Ro is the equilibrium exchange rate existing in the base period and R1 equals the
estimated target at which the actual rate should be in the future.
2.2.1 Absolute PPP (Law of One Price)
This is the simplest concept of the model of PPP. For analysis, it assumes the following: It is
costless to transport commodities between nations; and there are no barriers to trade (such as
tariffs). Given the assumptions, the law of one price asserts that identical goods should be
sold at a similar price or cost in all nations. However, before the costs of goods in different
countries can be compared, prices must first be converted in to a common currency. Once
converted at the current market exchange rate, the prices of identical goods from any two
countries should be identical.
Tools purchased in Ethiopia should cost the equal dollars as identical machine tools bought in
the United States. According to this version, the exchange rate between any two currencies is
simply the ratio of the two countries ‗general price levels. For instance, if the price of a kilo
of sugar is $1 in the United States and Br. 9 in Ethiopia, then the exchange rate between the
birr and the dollar should be R = Br.9/$ 1= 9 (according to the law of one price).
2.3. Money, Interest rate and Exchange rat
2.3.1 .A Brief Review of the Money Market
Before learning about the determinants of the demand for and supply of money we need to
define what money is and how we measure it. As the word money is used in everyday
conversation, it can mean many things but to economists it has a very specific meaning.
Economists define money (also referred to as the money supply) as anything that is generally
accepted in payment for goods or services or in the repayment of debts when most people talk
about money, they are talking about currency.
3.2.2. The Basic Functions of Money
In every society, money performs four basic functions. All of these functions play significant
roles in the operation of the economy. The Medium of Exchange Function:-The most basic
function of money is to serve as the medium of exchange. In almost all market transactions in
our economy, money in the form of currency or checks is a medium of exchange.
Money as a unit of account:-The second role of money is to provide a unit of account that
is, it is used to measure value in the economy. We measure the value of goods and services in
terms of money. Just as we measure weigh in terms of pounds or distance is terms of miles.
Money as a store of value (wealth holding):-Money also functions as a store of value; it is a
repository of purchasing power over time. A store of value is used to save purchasing power
from the time income is received until the time it is spent.
Money as a Standard of Deferred payment:-Money lets you buy now and pay later. Or It
lets you lend now and collect later. When people save money, that money can be borrowed
and channeled in to investments it is the deferred payments function of money which permits
this transfer of spending power from earner.
Money supply
The supply of money consists of currency – paper money and coins in the hands of the
nonblank public plus demand deposits – checking account balances in commercial banks.
The supply of money is a stock at a particular point of time – or the supply of money at any

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moment is the total amount of money in the economy. Friedman defines money supply in
broader sense:
Demand for money
Why people prefer to keep their asset in the form of cash rather than other form of asset? In
other words why people demand money?
First, people hold cash to smooth their daily transactions (receipts and payments)
This implies the demand for money, which is known as transaction demand for money has
positive association with real income of individuals. If Transaction demand denoted by K(y)
( )
then,
Secondly people hold cash as alternative form of asset by comparing with the return obtain
from the other alternative forms. That is the demand for money depends on cost of holding
money. As summary
The cost of holding money is the interest rate that is forgone by holding money rather than
keeping in the form of interest bearing asset such as bonds and bank deposits.
The most basic function of money is to serve as the medium of exchange. In almost all
market transactions in our economy, money in the form of currency or checks is a medium of
exchange; it is used to pay for goods and services. The second role of money is, it is used to
measure value in the economy. We measure the value of goods and services in terms of
money. Just as we measure weigh in terms of pounds or distance is terms of miles. Money
also functions as a store of value; it is a repository of purchasing power over time. A store of
value is used to save purchasing power from the time income is received until the time it is
spent. This function of money is useful because most of us do not want to spend our income
immediately up on receiving it but rather prefer to wait until we have the time or the desire to
shop.
When people save money, that money can be borrowed and channeled in to investments it is
the deferred payments function of money which permits this transfer of spending power from
earner – savers to borrower – spenders. It permits the easy transfer of resources out of their
less desired (less productive less profitable) uses and in to their more desired (more
productive, more profitable) The supply of money consists of currency – paper money and
coins in the hands of the nonblank public plus demand deposits – checking account balances
in commercial banks. The supply of money is a stock at a particular point of time – or the
supply of money at any moment is the total amount of money in the economy People hold
cash to smooth their daily transactions (receipts and payments). The daily transaction of
people however depends on their real income. As income increases the transaction in which
peoples involve increases. Therefore they hold more cash to cover the transactions.
According to theory of liquidity preference, money market equilibrium attained through
adjustment of portfolio of asset holding. The purchasing power parity serves as a tool for
cross-country comparisons of income and wages, which is used by international organizations
like the World Bank in presenting much of their international data.
3. BALANCE OF PAYMENTS
3.1. Definition and Purposes of Balance of Payments
The Balance of Payments is a record (summary statement) of the economic transactions
between the residents of one country and the residents of all other countries during a
particular period of time, usually a calendar year.
BOP is recorded usually for a Calendar year. In other words B O P is a systematic statistical
statement or record of the character and dimensions of the country‗s economic relationship
with the rest of the world. Balance of payments is integral parts of national accounts for an
open economy. The main purpose of the Balance of Payment is to inform the Government of
the international economic position of the nation and to help in formulating it‘s of monitory,
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fiscal and trade policies. The Foreign Governments also use the Balance of Payment accounts
for the purpose of formulating trade relation with other countries

3.2. Balance of Payments Accounting Principle

the balance of payments in essentially an application of double– entry bookkeeping, since it
records both transactions and the money flows associated with those transactions. This, in
other words means that the arrangement of international transactions in to a balance of
payments account requires that each transaction be entered as a credit or a debit.
A debit transaction is a transaction that leads to a payment to foreigners and credit transaction
is one that results in a receipt of a payment from foreigners in such a way that debit
transactions are entered with a negative sign and credit transactions are entered with a
positive sign in the balance of payments of the country.
3.2.1. Components of balance of payments
There are two basic elements in a perfectly compiled set of balance of payments: the current
account and the capital account. Each of these is usually subdivided, the former into visible
and invisible trade and unrequited transfers, the latter into long –term and short –term private
transactions and changes in official reserves. The essential difference between the two is that
capital account transactions necessarily involve domestic residents either acquiring or
surrendering claims on foreign residents, whereas current account transactions do not.
3.2.2. Balance of Trade and Balance of Payments
3.2.2.1. Balance of Trade (BoT) and Balance of Payments Disequilibria
If the two sums, that is the value of exports and imports are equal to each other, it is called
balance of trade equilibrium. If the sum of exports exceeds that of the sum of imports, the
balance of trade is exhibiting surplus and called favorable trade balance, if the sum of imports
exceeds that of the sum of exports, the balance of trade is in deficit and called unfavorable
trade balance. The balance of trade is the official term for net exports that makes up the
balance of payments. The official balance of trade is separated into the balance of
merchandise trade for tangible goods and the balance of services. A balance of trade surplus
is most favorable to domestic producers responsible for the exports. However, this is also
likely to be unfavorable to domestic consumers of the exports who pay higher prices. A
surplus in BoPs results when the autonomous credit receipts exceed the autonomous debit
payments and a deficit in the BoPs occurs when the autonomous payments (debits) exceed
the value of autonomous receipts (credits).
Alternatively, a balance of trade deficit is most unfavorable to domestic producers in
competition with the imports, but it can also be favorable to domestic consumers of the
exports who pay lower prices. The sum of accommodating transaction entered as credit in the
international liquidity account is the measure of a deficit in the BoPs. While a similar debit
(negative) entry of that account is the measure of a surplus in the BoPs.
To correct the imbalance it is possible to use
Deflation: In the wake of Deficit in a nation‗s Balance of Payments it can resort to tight
monetary policy. The currency authority may try to lower the prices by reducing the quantity
of money in circulation or follow a deflationary monetary policy. Deflation is the classical
medicine for correcting the deficit in the balance of payments. Deflation refers to the policy
of reducing the quantity of money in order to reduce the prices and the money income of the
people.
Depreciation: Another method of correcting disequilibrium in the balance of payments is
depreciation or appreciation of the exchange rate. Deprecation means a fall in the rate of
exchange of one currency (home currency) in terms of another (foreign currency). A currency
will depreciate when its supply in the foreign exchange market is large in relation to its
demand.
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Devaluation: Devaluation refers to the official reduction of the external values of a currency.
The difference between devaluation and depreciation is that while devaluation means the
lowering of external value of a currency by the government, depreciation means an automatic
fall in the external value of the currency by the market forces; the former is arbitrary and the
latter is the result of market mechanism. Thus, devaluation serves only as an alternative
method to depreciation.
3.3. Approaches to Balance of Payments
3.3.1. The Elasticity Approach
What is currency devaluation?
currency devaluation (depreciation) affects a country‗s balance of trade through changes in
the relative prices of goods and services internationally. A trade deficit nation may be able to
reverse its imbalance by lowering its relative prices, so that exports increase and imports
decrease. The nation can lower relative prices by permitting its exchange rate to depreciate in
a free market or formally devaluing its currency under a system of fixed exchange rates. The
ultimate outcome of currency depreciation (devaluation) depends on the price elasticity of
demand for a nation‗s imports and its exports.
The Marshal Lerner condition states:
1. Devaluation (depreciation) will improve the trade balance if the devaluing nation‗s demand
elasticity for imports plus the foreign demand elasticity for the nation‗s exports exceeds
2. If the sum of the demand elasticity‗s in less than 1, devaluation will worsen the trade
balance.
3. The trade balance will be neither helped nor hurt if the sum of the demand elasticity‗s
equals 1.
3.3.2. The Absorption Approach to Exchange Rate Adjustment
According to the elasticity‗s approach, currency devaluation offers a price incentive to reduce
imports and increase exports. But even if elasticity conditions are favorable, whether the
home country‗s trade balance will actually improve may depend on how the economy reacts
to the devaluation. The absorption approach provides insights into this question by
considering the impact of devaluation on the spending behavior of the domestic economy and
the influence of domestic spending on the trade balance.
The absorption approach starts with the idea that the value of total domestic output (Y) equals
the level of total spending. Total spending consists of consumption (C), investment (I),
government expenditure (G) and net exports (X-M. That is:-Y = C+I +G+ (X-M).
3.3.3. The Monetary Approach to Exchange Rate Adjustment
According the monetary approach, currency devaluation may induce a temporary
improvement in a nations BOPs position. Assume, for instance, that equilibrium initially
exists in the home country‗s money market. A devaluation of the home currency would
increase the price level (that is, the domestic currency prices of potential imports and
exports). This increases the demand for money because larger amounts of money are needed
for transaction. If that increased demand is not fulfilled from domestic sources, an inflow
results in a BOPs surplus and a rise in international reserves. But this surplus doesn.t last
forever. By adding to the international component of the home – country money supply, the
devaluation leads to an increase in spending (absorption), which reduces the surplus. The
surplus eventually disappears when equilibrium is restored in the home country‗s money
market. The effects of devaluation on real economic variables are thus temporary. Over the
long run, currency devaluation merely raises the domestic price level.

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4. MACROECONOMIC POLICY IN AN OPEN ECONOM
What is Open Economy Macroeconomics?
the key macroeconomic difference between open and closed economies is that, in an open
economy, a country‗s spending in any given year need not equal its output of goods and
services. A country can spend more than it produces by borrowing from abroad, or it can
spend less than it produces and lend the difference to foreigner. In an open economy gross
domestic product (GDP) differs from that of a closed economy because there is an additional
injection-export expenditure which represents foreign expenditure on domestically produced
goods.
There is also an additional leakage, expenditure on imports which represents domestic
expenditure on foreign goods and which raises foreign national income. The identity for an
open economy is given by: Y = C + I + G + X – M, where Y is national income, C is
domestic consumption, I is domestic investment, G is government expenditure, X is export
expenditure and M is import expenditure.
If we deduct taxation from the right-hand side of equation, we have:-Yd = C + I + G + X – M
–T, where Yd is disposable income and if we denote private savings as S = Yd– C we can
rearrange equation to obtain:
4.1. Macroeconomic Policy Goals in an Open Economy
The overarching goals of macroeconomics are to maximize the standard of living and achieve
stable economic growth. The goals are supported by objectives such as minimizing
unemployment, increasing productivity, controlling inflation, and more.
4.2. Stabilization Policies
Macroeconomic stabilization is a condition in which a complex framework for monetary and
fiscal institutions and policies is established to reduce volatility and encourage welfare-
enhancing growth.
Macroeconomic stability exists when key economic relationships are in balance—for
example, between domestic demand and output, the balance of payments, fiscal revenues and
expenditure, and savings and investment. These relationships, however, need not necessarily
be in exact balance. Imbalances such as fiscal and current account deficits or surpluses are
perfectly compatible with economic stability provided that they can be financed in a
sustainable manner.
4.3. International Macroeconomic Policy Coordination
A closer form of international cooperation is policy coordination. All countries involved in
the coordination have their own preferences as regards the future values of their economic
policy objectives. They are aware of the mutual influence exerted by national economic
policy. The ultimate aim of policy coordination is that individual countries should adjust their
policy instruments in the best interests of all the economic objectives of the countries
concerned. In theoretical form: the econometric model containing all the countries concerned
includes all national economic objectives and economic policy instruments; there is also an
objective function comprising all countries and containing all national objectives, each in
relation to the target value for that objective, with a specific weighting which expresses the
importance of the objective concerned. The aim is to maximize the objective function under
the condition of the econometric model. This process yields the optimum value of each of the
national policy instruments, in the best interests of the group of countries concerned -
although it cannot be precluded that the result of this optimization is that some countries'
welfare declines.

4.4. Fiscal Policy: Tools of Fiscal Policy

Fiscal policy is the use of government spending and taxation to influence the economy.
Governments typically use fiscal policy to promote strong and sustainable growth and reduce
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poverty. The two main tools of fiscal policy are taxes and spending. Taxes influence the
economy by determining how much money the government has to spend in certain areas and
how much money individuals should spend. For example, if the government is trying to spur
consumer spending, it can decrease taxes.
Monetary Policy: Tools of Monetary Policy
Monetary policy is a set of tools used by a nation's central bank to control the overall money
supply and promote economic growth and employ strategies such as revising interest rates
and changing bank reserve requirements.
Central banks have four main monetary policy tools: the reserve requirement, open market
operations, the discount rate, and interest on reserves. Most central banks also have a lot more
tools at their disposal.

4.5. Advantages of international economic cooperation

The advantage of international economic cooperation is undeniably that the effects on other
countries' economies are taken into account in determining national policy.
5. International Monetary System and Key International Financial Institutions
The international monetary system is a set of conventions and rules that support cross-border
investments, trades, and the reallocation of capital between different countries. These rules
define how exchange rates, macroeconomic management, and balance of payments are
addressed between nations.
Throughout history, the International Monetary System (IMS) has gone through radical
transformations that have shaped global economic outcomes. It has been the constant focus of
world powers, has fostered innumerable international policy initiatives, and has captured the
imagination of some of the best economic minds.
We consider the IMS as the collection of three key attributes: (i) the supply of and demand
for reserve assets; (ii) the exchange rate regime; and (iii) international monetary institutions.
A major contribution of our paper is to show how the modern theoretical apparatus a
developed to analyze sovereign debt crises, oligopolistic competition, and Keynesian
macroeconomics, can be combined to build a theoretical equilibrium framework of the IMS.1
Our framework provides a collection of new insights. It also allows us to match the historical
evidence, to make sense of the leading historical debates, and to demonstrate their current
relevance
5.1. The Evolution of an International Monetary System
The current IMS took shape in the years following the Asian crisis (1997-98) and the advent
of the euro (1999). This system can be seen as an evolution from the two previous systems,
the Bretton Woods system of fixed exchange rates and the subsequent system center on three
major floating currencies. (The US dollar, Japanese yen and Deutsche Mark), on which Box 1
provides more detail.
Its start was marked by two major developments. The first was the materialization of a
revitalized US dollar area, encompassing the United States and a new group of key creditors
which, unlike in the previous phase, had become systemically important: namely, certain
economies in emerging East Asia – especially China – and the Gulf oil exporters. Dooley,
Folkerts-Landau and Garber (2003) labelled this arrangement the ―revived Bretton Woods‖
or ―Bretton Woods II‖. We will in turn refer to the current IMS as the ―mixed‖ system, to
highlight the assortment of floating and fixed currency regimes of its core actors. The second
development was the advent of a major monetary union with a new globally important
floating currency, the euro, which – despite some weaknesses inherent in its status as a
―currency without a state‖ has rapidly become a credible alternative to the US dollar, though
without undermining its central role in the IMS.

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5.1.1. The Gold Standard
The use of gold coins dates back to antiquity. The international gold standard, however,
flourished in a brief period of history, emerging the 1870s and collapsing with the outbreak of
World War I in 1914. The pure gold standard provides the clearest example of the fixed
exchange rate system. It has the following three distinguishing features: (i) the government
fixes the price of gold and then fixes the value of its money in terms of gold. (ii) The
government is committed to ensure convertibility of the currency. In other words, the
government will, on demand, buy and sell gold at the official rate. If you have gold, you can
get it converted into the domestic currency at the fixed rate. Or, if you want gold, you can
walk into the central bank, buy gold at the fixed rate, and walk away with gold. (iii) The
government provides a 100% gold backing (or 100% cover). It creates money when it buys
gold and destroys money only by selling gold. For instance, fewer than 100% cover if the
public buys $100 worth of gold from the central bank, there is a one-for-one reduction in the
stock of money outstanding. A one-for-one increase in money supply takes place when the
central bank buys gold for currency.
Balance of Payment Adjustment under the Gold Standard
Under the pure gold standard, the exchange rate is absolutely fixed. Suppose that US and
Britain follow the gold standard rules - a fixed par value, convertibility and 100 percent
cover. Now if the pure value of gold in US is $20.00 per ounce and that in Britain is £5 per
ounce, the exchange rate between the pound sterling and the US dollar is thereby fixed at $4
per pound ($20/£5). Why is this so? Suppose that the price of a pound sterling is more than
$4. Instead of buying pounds directly, I can buy one-fifth of an ounce of gold in US for $4,
ship it to Britain, and get one pound from the Bank of England. For the same reason, the price
of a pound cannot fall below $4. If I have £1, I can buy one-fifth of an ounce of gold from the
Bank of England, ship it to US and get $4 from the Federal.
5.2. Key International Financial Institutions

5.2.1. The World Bank, International Monetary Fund and World Trade Organization

5.2.2. The World Bank

The World Bank is like a cooperative, where its 184 member countries are shareholders. The
shareholders are represented by a Board of Governors, who is the ultimate policy makers at
the World Bank. Generally, the governors are member countries' ministers of finance or
ministers of development.
Conceived during World War II at Bretton Woods, New Hampshire, the World Bank initially
helped rebuild Europe after the war. Its first loan of $250 million was to France in 1947 for
post-war reconstruction. Reconstruction has remained an important focus of the Bank's work,
given the natural disasters, humanitarian emergencies, and post conflict rehabilitation needs
that affect developing and transition economies.

Nowadays the Bank, however, has sharpened its focus on poverty reduction as the
overarching goal of all its work. It once had a homogeneous staff of engineers and financial
analysts, based solely in Washington, D.C. Today, it has a multidisciplinary and diverse staff
including economists, public policy experts, sectoral experts, and social scientists. 40 percent
of staff is now based in country offices.

The Bank itself is bigger, broader, and far more complex. It has become a Group,
encompassing five closely associated development institutions:

 The International Bank for Reconstruction and Development (IBRD),

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  The International Development Association (IDA),
 The International Finance Corporation (IFC),
 The Multilateral Investment Guarantee Agency (MIGA), and
 The International Centre for Settlement of Investment Disputes (ICSID).

The World Bank's two closely affiliated entities—the International Bank for
Reconstruction and Development (IBRD) and the International Development Association
(IDA)—provide low or no interest loans and grants to countries that have unfavorable or
no interest loans and grants to countries that have unfavorable or no access to
international credit markets.

Fund Generation

IBRD lending to developing countries is primarily financed by selling bonds in the world's
financial markets. While IBRD earns a small margin on this lending, the greater proportion of
its income comes from lending out its own capital. This capital consists of reserves built up
over the years and money paid in from the bank's 184 member country shareholders. IBRD‘s
income also pays for World Bank operating expenses and has contributed to IDA and debt
relief.

IDA, the world's largest source of interest-free loans and grant assistance to the poorest
countries, is replenished every three years by 40 donor countries. Additional funds are
regenerated through repayments of loan principal on 35-to-40-year, no-interest loans, which
are then available for re-lending.

Loans

Through the IBRD and IDA, the bank offers two basic types of loans and credits.

 Investment loans: Investment loans are made to countries for goods, works and
services in support of economic and social development projects in a broad range of
economic and social sectors.
 Development policy loans: Development policy loans (formerly known as
adjustment loans) provide quick-disbursing financing to support countries‘ policy and
institutional reforms

5.2.3. International Monetary Fund (IMF)

The IMF was born at the end of World War II, out of the Bretton Woods Conference in 1945.
The Fund was created out of a need to prevent economic crises like the Great Depression.
The main purposes for which the I.M.F. was set up were to provide exchange stability,
temporary assistance to countries falling short of foreign exchange and international
sponsoring of measures for curing fundamental causes of disequilibrium in balance of
payments. The I.M.F. is a pool of central -bank reserves and national currencies which are
available to its members under certain conditions. It can be regarded as an extension of the
central bank reserves of the member countries. The IMF works to the creation of financial
markets worldwide and to the growth of developing countries. With its sister organization,
the World Bank, the IMF is the largest public lender of funds in the world. It is a specialized
agency of the United Nations and is run by its 184 member states. Membership is open to any
country that conducts foreign policy and accepts the statutes of the Fund.
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Objectives of IMF

According to Article I of the Fund, the main purposes of the Fund are:
1. To promote international monetary cooperation through a permanent institution.
To facilitate the expansion and balanced growth of international trade, and to contribute the
promotion and maintenance of high, levels of employment of the member-countries.
1. To promote exchange stability, to maintain orderly exchange arrangements among
members, and to avoid competitive exchange deprecia1ion.
2. To assist in the establishment of a multilateral system of payments in respect of
current' transaction between members and in the elimination of foreign exchange
restrictions. .
3. To give confidence to members by making the Fund's resources available to them
under adequate safeguards, thus providing them with opportunity to correct
maladjustments in their balance of payments without resorting to measures
destructive of national or international prosperity (e.g., deflationary policies).
4. In accordance with the above, to shorten the duration and lessen the degree of
disequilibrium in the international balance of payments of members.

Functions of the IMF

 It serves as a short-term credit institution
 The Fund provides a mechanism for improving short-term balance of payments
position
 The Fund provides machinery for international consultations
 It provides a reservoir of the currencies of the member-countries and enables
members to borrow one another's currency.
 It promotes orderly adjustment of exchange rates to promote exchange stability
5.2.4. World Trade Organization (WTO)

The World Trade Organization (WTO) is an international, multinational organization,

which sets the rules for the global trading system and resolves disputes between its member
states; all of whom are signatories to its approximately 30 agreements.

The Bretton Woods Conference of 1944 proposed the creation of an International Trade
Organization (ITO) to establish rules and regulations for trade between countries. Members
of the UN Conference on Trade and Employment in Havana agreed to the ITO charter in
March 1948, but ratification was blocked by the U.S. Senate (WTO, 2004b). Some historians
have argued that the failure may have resulted from fears within the American business
community that the International Trade Organization could be used to regulate (rather than
liberate) big business (Lisa Wilkins, 1997; Helen Milner 1993).Only one element of the ITO
survived: the General Agreement on Tariffs and Trade (GATT).

Seven rounds of negotiations occurred under the GATT before the eighth round - known as
the Uruguay Round - which began in 1984 and concluded in 1995 with the establishment of
the WTO. The GATT principles and agreements were adopted by the WTO, which was
charged with administering and extending them and approximately 30 other agreements and
resolving trade disputes between member countries. Unlike the GATT, the WTO has a
substantial institutional structure. The WTO aims to increase international trade by promoting
lower trade barriers and providing a platform for the negotiation of trade and to their
business.
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Principles of the trading system

The WTO discussions follow the following fundamental principles of trading.

1. A trading system should be free of discrimination in the sense that one country cannot
privilege a particular trading partner above others within the system, nor can it
discriminate against foreign products and services.
2. A trading system should tend toward more freedom, that is, toward fewer trade
barriers (tariffs and non-tariff barriers).
3. A trading system should be predictable, with foreign companies and governments
reassured that trade barriers will not be raised arbitrarily and that markets will remain
open.
4. A trading system should tend toward greater competition.
5. A trading system should be more accommodating for less developed countries,
giving them more time to adjust, greater flexibility, and more privileges

Development Economics I
CHAPTER ONE
Economics and Development Studies
Definition
Development: The process of improving the quality of all human lives and capabilities by
raising people‘s levels of living, self-esteem, and freedom. Developing countries: Countries
of Asia, Africa, the Middle East, Latin America, and Eastern Europe that are presently
characterized by low levels of living and other development deficits.
The Nature of Development Economics
Traditional economics: An approach to economics that emphasizes utility, profit
maximization, market efficiency, and determination of equilibrium. It is concerned primarily
with the efficient, least-cost allocation of scarce productive resources and with the optimal
growth of these resources over time so as to produce an ever-expanding range of goods and
services. It assumes economic ―rationality‖ and a purely materialistic, individualistic, self-
interested orientation toward economic decision making. Political economy: The attempt to
merge economic analysis with practical politics—to view economic activity in its political
context. Development economics: The study of how economies are transformed from
stagnation to growth and from low income to high-income status, and overcome problems of
absolute poverty.
The meaning of Economic growth and development
According to professor Bonne, Development requires and involves some sort of direction,
regulation and guidance to generate the forces of expansion and maintain them. According to
Maddison, ―The raising of income levels is generally called economic growth, in rich
countries, and in poor ones it is called economic development". Even though economic
growth and development are sometimes used synonymously in economic discourse,
economic growth refers to a rise in per capita GDP, whereas economic development is more
than economic growth.
Economic development implies (in addition to the rise in per capita income) fundamental
change in the structure of the economy. That is, a falling share of agriculture in GDP, a rising
share of industry in GDP and rising share of population living in cities (urban areas) rather
than in rural areas.
Furthermore, Economic development also implies that the country must participate in the
process that brought the major structural change or changes in income. In general,
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Development embraces the major economic and social objectives and values that societies
strive for. According to Todaro: DEV is ―conceived as a multi-dimensional process involving
major changes in social structures, popular attitudes, and national institutions, as well as the
acceleration of economic growth, the reduction of inequality (and unemployment), and the
eradication of absolute poverty‖.
Core values of development
Life-sustenance: life-sustenance is concerned with the provision of basic needs. No country
can be regarded as fully developed if it cannot provide its entire people with such basic needs
as housing, clothing, food and minimum education. According to this approach when the
basic needs (i.e. food, shelter, health minimal education and protection) absent or in a critical
short supply we cannot say the country has fully developed. It implies that economic
development is a necessary condition to provide people with basic needs.
Self-esteem: this is concerned with the feeling of self-respect and independence or not being
used as a tool by others for their own need. no country can be regarded as fully developed if it
is exploited by others.
Freedom from servitude: Freedom is ability of people to determine their destiny. It involves
an expanded range of choices for societies and their members together with a minimization of
external constraints in the pursuit of devolvement. No man is free if she/he cannot choose; if
she/he is imprisoned by living on the margin of subsistence with no education and no skills.
The Objectives of Development
To increase the availability of basic life-sustaining goods like food, shelter, health and
protection; To generate greater individual and national self-esteem; and To expand the
range of economic and social choices available to individuals and the nation.
1.3. Current Interest in Development Economics
A number of factors can be pointed out that account for this change in attitude and upsurge of
interests in the economics of development and the economies of poor nations is due to. The
factors are Academic interest in development; the awareness of developing countries about
their backwardness and their demand for a new international economic order; and the
awareness of the world in general and developed countries in particular about the mutual
interdependence of the world economy.
Alternative Development
Among the developed alternative indicators the major once are the following: Human
Development Index (HDI) developed by UNDP, the Human Poverty Index, and Physical
quality of life index
The Human Development Index (HDI)
Human Development Index (HDI) –is an index measuring national socioeconomic
development, based on measures of life expectancy at birth, educational attainment, and
adjusted real per capita income. From the definition of HDI we can have three components,
which are essential in the construction and refinement of a Human Development Index. These
include: Longevity-measured by life expectancy at birth; Measure of educational attainment-
knowledge as measured by a weighted average of adult literacy (two-thirds) and mean years
schooling (one-third weight) that is combination of primary, secondary and Tertiary level
enrollments; and Standards of living: measured by real per capita GDP. HDI ranges from 0 to
1.
The HDI ranks countries into three groups: low human development (0.0 to 0.49), medium
human development (0.50 to 0.79), and high human development (0.80 to 1.00).
Human Poverty Index ( HPI)
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The Human Poverty Index (HPI) was an indication of the standard of living in a country,
developed by the United Nations (UN). It was first reported as part of the Human
Development Report in 1997. In 2010 it was supplanted/replaced by the UN's
Multidimensional Poverty Index. MPI reveals a different pattern of poverty than income;
poverty as it illuminates a different set of deprivations. It is a composite measure focuses on
dimensions of deprivations. The HPI for developing countries is based on three main indices:
a) The percentage of the population not expected to survive to the age of 40 (P1), b) The
adult illiteracy rate (P2), and c) A deprivation index based on an average of three variables: 1.
The percentage of the population without access to safe water; 2. the percentage of
population without access to health service; and 3. the percentage of the underweight children
under five years old (P3)
Physical Quality of Life Index (PQLI)
PQLI is an attempt to measure the quality of life or well-being of a country. The value is the
average of three statistics. Basic literacy rate, infant mortality, and life expectancy obstacles
to development of Africa. There are indeed two fundamental problems which may explain
why these economies are either stagnant or in regression.
 Internal Causes: Inability to solve internal conflicts, Inter-state conflicts including boarder
disputes, Administrative inefficiency, Inappropriate development models, Unrealistic
development strategies, Lack of viable institutions, Ethnicity and Political instability, The
existence of governments without legitimacy, Financial bureaucratic and political
corruption, Lack of transparency in public transactions and lack of accountability in
public action, Lack of trained people to educate and advise farmers, and Adverse weather
conditions.
 External Causes: The disturbing effects of the oil price rises, Policies advocated by the
WB and IMF, The burden of international debt and interest rate, Lack of adequate capital
flow and transfer of technology, and Erection of high tariff barriers.
The Basic Requirements for Development
The African region contains the growing world‘s share of absolute poor with little power to
influence the allocation of resources.
 Peace and Security: Political terror has systematically undermined both development
and security; and Peace is one of the preconditions for economic growth and economic
development.
 Governance and Leadership: In order for Africans to develop, they must be part of the
decision making process; Good governance enhances democracy as well as efficiency in
the economy; and this is important so that African people should claim ownership and
inclusive participation in globalization.
 Economic Growth: Export led growth is a development strategy that has been employed
with remarkable success in some parts of the world, especially Asia.
 Global Interdependence: Globalization is a process of integrating economic decision
making such as the consumption, investment and saving process all across the world; It is
a global market in which all nations are required to participate; and thus, for Africa‘s
development and confronting the 21st century, challenges must be ready and prepared for
globalization, the interdependence of states.
Chapter two
2.1. Common Characteristics of Developing Countries
There are seven broad categories by which we can classify the common characteristics of
developing countries.

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 Low levels of living characterized by low incomes, high inequality, poor health and
inadequate education. Low levels of living are manifested qualitatively and
quantitatively in the form of low incomes (poverty), inadequate housing, poor health and
limited or no education, high infant mortality, low life and work expectancy, and in many
cases, a general sense of sickness and hopelessness.
 Low levels of Productivity. In addition to low levels of living, relatively low levels of
labor productivity characterize developing countries. The concept of a production
function is often used to describe the way in which societies go about providing for their
material needs. But the mechanical technical concept of a production function for
example; Q= f (L, k) where Q = output, L = Labor and K = Capital, must be
supplemented by a broader conceptualization that includes among its other inputs
managerial competence, worker motivation, and institutional flexibility. Throughout the
developing world, levels of labor productivity (output per worker) are extremely low
compared with those in developed countries. This can be explained by a number of basic
economic problems. For example, the principle of diminishing marginal productivity
states that, if increasing amounts of a variable factor (labor) are applied to fixed amounts
of other factors (e.g. Capital, land, materials) , the extra or marginal product of the
variable factor declines beyond a certain number. Therefore, low levels of labor
productivity can therefore be explained by the absence or severe lack of ―Contemporary‖
factor inputs such as physical capital or experienced management in LDCs.
 To raise productivity, according to this argument, domestic savings and foreign finance
must be mobilized to generate new investment in physical capital goods and build up the
stock of human capital (e.g. Managerial skills) through investment in education &
training, Institutional changes are also necessary to maximize the potential of this new
physical and human investment. These charges might include such diverse activities as
the reform of land tenure, corporate tax, credit and banking structures; the creation or
strengthening of an independent, honest, and efficient administrative service, and the
restructuring of educational and training program to make them more appropriate to the
needs of the developing societies.
 High rates of population growth and dependency burden: Developing countries are
not only characterized by higher rate of population growth, but greater dependency
burdens than rich nation. Dependency burden is the proportion of the total population
aged 0 to 15 and 65 and above, which is economically unproductive and therefore not
counted in the labor force.
 High and rising levels of unemployment and underemployment: Underutilization of
labor is manifested in two forms. a) Open unemployment those people who are able and
often to work but for whom no suitable job is available. b) Underemployment those
people who work less than they could.
 Significant dependence on agricultural production and primary product exports.
Agriculture in many LDCs is characterized by high pressure on land, use of very
backward technology, low saving and investment and hence poor productivity. A large
majority of the peasants live in object poverty and the rate of literacy is also very poor.
The land is usually scattered and the fragmented and the distribution of land ownership is
disorganized in most cases.
 Dominance, dependence and Vulnerability in international relations. The dominant
power of the rich nations to control the pattern of international trade. Their ability to
dictate the terms in which technology, foreign aid and private capital are transferred to
developed Nations.
Chapter Three
The linear stages of growth
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The liner stages of growth were derived largely from the experience of how present
developed countries were transferred from agrarian economy to modern economy. Theorists
of the 1990s and early 1960s viewed the process of development as a series of successive
stages of economic growth through which all countries must pass. It was primarily an
economic theory of development in which the right quantity and mixture of saving,
investment, and foreign aid were all that was necessary to enable developing countries to
proceed along an economic growth path that historically had been followed by the more
developed countries.
We are going to divide the linear stages of growth in to three main models of growth:
Namely,
2. Rostow's stages of growth, 2. The Harrod-Domar growth model and 3. The Solow
growth model.
Rostow's stages of growth
This model is highly influenced by Economist called Walt Rostow. According to the Rostow
doctrine, the transition from underdevelopment to development can be described in terms of a
series of steps or stages through which all countries must proceed. Rostow identified stages
of economic growth that societies have to pass through as follows. The traditional society;
Pre-condition for the takeoff; Take-off stage; Drive to maturity and stages of self-sustained
growth and The age of high consumption-
Traditional society or Pre-Industrial stage.
Traditional Society Characterized by The economy is dominated by subsistence activity;
existence of barter; Agriculture is the most important industry Output is consumed by
producers; it is not traded nor recorded; Production is labor intensive using only limited
quantities of capital; Technology is limited; resource allocation is determined very much by
traditional methods of production; People stick to age old customs and traditions output per
worker is very low and doesn‘t change from time to time; In this stage, there may be craft
industries with strong social stratification; and The world is in this stage before 19th century
―Industrial Revolution"
Transitional Stage (Preconditions for Takeoff
Development of mining industries; Increase in capital use in agriculture; Necessity of
external funding; some growth in savings and investment; increased specialization generates
surpluses for trading; emergence of a transport infrastructure to support trade; Entrepreneurs
emerge as incomes, savings and investment grow; External trade also occurs concentrating on
primary products; strong central government encourages private enterprise; in this stage the
economy is more open to modern technology and preparing itself for takeoff; a start of
construction of roads and railways, growing export, new political and economic elites and
high external influence; and Investment ranged around 5% of the GNP in this stage.
The take-off stage
Increasing industrialization; further growth in savings and investment; some regional growth;
Number employed in agriculture declines; industrial growth may be linked to primary
industries. The level of technology required will be low; Industrialization increases with
workers switching from the agricultural sector to the manufacturing sector; Growth is
concentrated in a few regions of the country and within one or two manufacturing industries;
The level of investment reaches over 10% of GNP; People save money; barriers to growth are
overcomed and growth becomes a normal condition at least in one sector of the economy
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(the leading sector); political, social and institutional setup favors dynamic growth; The
growth is self-sustaining as investment leads to increasing incomes in turn generating more
savings to finance further investment; and a country may be in the take-off period for two to
three decades.
Drive to Maturity
As the economy matures, technology plays an increasing role in developing high value added
products. Growth becomes self-sustaining – wealth generation enables further investment in
value adding industry and development Industry more diversified. Increase in levels of
technology utilized; the economy is diversifying into new areas; technological innovation is
providing a diverse range of investment opportunities; the economy is producing a wide
range of goods and services and there is less reliance on imports; urbanization increases; and
technology is used more widely.
High Mass Consumption
Service sector dominates the economy –i.e. banking, insurance, finance, marketing,
entertainment, leisure and so on; High output levels, Mass consumption of consumer durable
goods; High proportion of employment in service sector; In this last stage, the per capital
income becomes so high that the consumption transcends beyond food, clothes and shelter to
goods of comforts and luxuries or a mass scale urbanization and industrialization change the
values of the society and development. In this stage people do not feel any pinch of shortages.
I.e. Very high levels of consumption and physical quality of life are achieved. The economy
is geared towards mass consumption, and the level of economic activity is very high;
Technology is extensively used but its expansion slows; the service sector becomes
increasingly dominant; Urbanization is complete; and increased interest in social welfare.
The Harrod-Domar Growth model
The model takes its name from a synthesis of analyses of the growth process by two
economists, sir Roy Harrod of Britain and E.V. Domar of the United States. It is based on
the experience of advanced economies. Economic growth can be thought of a result of
abstention from current consumption i.e. saving matter. Consider a farmer who needs only
sorghum seed to produce what he requires for his decent life. If he wants to increase output
more than he used to produce, all he needs to do is increase the amount of seed by foregoing
current consumption. The act of increasing the stock of seed is investment while the total
accumulated level of seed is capital stock. In general, capital stock is the machinery,
equipment, and the like which is used to produce output, and investment is the flow of output
to increase or maintain capital stock. Current output (Yt) is the sum of what is consumed (Ct)
and saved ( St) Yt = Ct +St Assuming that what is saved is invested(It). The Harod-Domar
equation s/ θ = g +δ relates growth of an economy to two fundamental variables; the ability of
the economy to save( s) and the capacity( efficiency) of capital to produce (θ ) low capital
output ratio.
The Solow Growth Model

The Solow growth model which is the formal starting point of modern growth theory is based
on two fundamental equations. Production function (from the supply side) and Capital
accumulation equation (from the demand side). He used the Cobb-Douglass production
function = 𝐾𝛼𝐿1− Where Y= output, K = capital, L = labor.

Assumptions:
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4. Constant returns to scale: The production function is homogenous of degree one. That is,
it has a constant returns to scale, and as such scaling up of inputs by a factor z scales up
output by the same factor z.
5. Diminishing returns to factor inputs: As factor inputs (labor Economic Growth and
capital) increase, output increases but the rate at which output increases tends to decline
as more of each input is used while either of the two is held to be constant.
6. Labor force equals population

Steady State Equilibrium

By expanding our model to include population growth our model more closely resembles the
sustained economic growth observable in much of the real world. To see how population
growth affects the steady state we need to know how it affects the accumulation of capital per
worker. When we add population growth (n) to our model the change in capital stock per
worker becomes Δk = i – (δ+n)k. As we can see population growth will have a negative
effect on capital stock accumulation. We can think of (δ+n)k as break-even investment or the
amount of investment necessary to keep capital stock per worker constant. Our analysis
proceeds as in the previous presentations. To see the impact of investment, depreciation, and
population growth on capital we use the (change in capital) formula from above, Δk = i –
(δ+n)k. substituting for (i) gives us, Δk = s*f(k) – (δ+n)k.
Steady State Equilibrium with population growth
At the point where both (k) and (y) are constant it must be the case that, Δk = s*f(k) – (δ+n)k
= 0 or, s*f(k) = (δ+n)k this occurs at our equilibrium point k*.
The impact of population growth
Like depreciation, population growth is one reason why the capital stock per worker shrinks.
The model predicts that economies with higher rates of population growth will have lower
levels of capital per worker and lower levels of income.
The efficiency of labour
We rewrite our production function as Y=F(K,L*E) where ―E‖ is the efficiency of labour.
―L*E‖ is a measure of the number of effective workers. The growth of labour efficiency is
―g‖.
Our production function y=f(k) becomes output per effective worker since y=Y/(L*E) and
k=K/(L*E). With this augmentation ―δk‖ is needed to replace depreciating capital, ―nk‖ is
needed to provide capital to new workers, and ―gk‖ is needed to provide capital for the new
effective workers created by technological progress.
Steady State Equilibrium with population growth and technological progress
At the point where both (k) and (y) are constant it must be the case that, Δk = s*f(k) –
(δ+n+g)k = 0 or, s*f(k) = (δ+n)k this occurs at our equilibrium point k*.
The impact of technological progress
Suppose the worker efficiency growth rate changes from g to g . This shifts the line
1 2
representing population growth, depreciation, and worker efficiency growth upward. At the
new steady state k2* capital per worker and output per worker are lower. The model predicts

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that economies with higher rates of worker efficiency growth will have lower levels of capital
per worker and lower levels of income.
Effects of technological progress on the golden rule
With technological progress the golden rule level of capital is defined as the steady state that
maximizes consumption per effective worker. Following our previous analysis steady state
consumption per worker is c* = f(k*) – (δ + n + g)k*
To maximize this MPK = δ + n + g or MPK – δ = n + g. That is, at the Golden Rule level of
capital, the net marginal product of capital MPK – δ, equals the rate of growth of total output,
n+g.

Structural-change theory

They hypothesis that under development is due to underutilization of resources arising from
structural or institutional factors that have their origins in both domestic and international
dualism. Development therefore requires more than just accelerated capital formation.
Structural transformation: is the process of transforming an economy in such a way that the
contribution to national income by the manufacturing sector eventually surpasses the
contribution by the agricultural sector.

The Lewis Theory of Development

Prof. Arthur Lewis has developed a very systematic theory of economic development with
unlimited supply of labour. Lewis' model starts with the assumption of a dual economy with a
modern industrial sector and a traditional subsistence sector. Lewis believed that in the
traditional sector of many underdeveloped countries there is unlimited supply of labour at
subsistence wage. Lewis two-sector model: A theory of development in which surplus labor
from the traditional agricultural sector is transferred to the modern industrial sector, the
growth of which absorbs the surplus labor, promotes industrialization, and stimulates
sustained development.

Surplus Labour means the existence of such a large population in the rural sector so that the
marginal productivity of labour has fallen to zero. This condition is also called disguised
unemployment. The essence of the development process in this type of an economy is the
transfer of labor resources from the agricultural sector where they add nothing to production
to the more modern industrial sector, where they create a surplus. Economic development
takes place when capital accumulates as a result of withdrawal of surplus labour from the
subsistence to the modern industrial sector. In the Lewis two-sector model of economic
development, surplus labor refers to the portion of the rural labor force whose marginal
productivity is zero or negative.

Dualism Theory

Dualism is the coexistence of two situations or phenomena (one desirable and the other not)
that are mutually exclusive to different groups of society. Dualism represents the
existence and persistence of increasing divergences between rich and poor nations and rich
and poor peoples at all levels. The concept embraces four key arguments: Superior and
inferior conditions can coexist in a given space at given time. The coexistence is chronic and

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not transitional. The degrees of the conditions have an inherent tendency to increase Superior
conditions serve to develop under development.

The theory of big –push

The theory of the big push is developed by prof. P.N. Rosesnstien-Rodan the most
famous coordination failures model in the development. The first factory can sell some of its
goods to its own workers, but no one spends all of one‘s income on a single good. Each time
an entrepreneur opens a factory, the workers spend some of their wages on other products. So
the profitability of one factory depends on whether another one opens, which in turn depends
on its own potential profitability, and that in turn depends on the profitability of still other
factories. Such circular causation should now be a familiar pattern of a coordination failure
problem. Big push A concerted, economy wide, and typically public policy–led effort to
initiate or accelerate economic development across a broad spectrum of new industries and
skills. It states that a big push or a large comprehensive program is needed to overcome
obstacles of growth It also states that proceeding ―bit by bit‖ will not launch the economy
successfully on the development path rather a minimum amount of investment is a necessary
condition for development. Moreover, the first factory has to train its workers, who are
accustomed to a subsistence way of life. The cost of training puts a limit on how high a wage
the factory can pay and still remain profitable. But once the first firm trains its workers, other
entrepreneurs, not having to recoup training costs, can offer a slightly higher wage to attract
the trained workers to their own new factories. However, the first entrepreneur, anticipating
this likelihood, does not pay for training in the first place. No one is trained, and
industrialization never gets under way. The big push is a model of how the presence of
market failures can lead to a need for a concerted economy wide and probably public-policy-
led effort to get the long process of economic development under way or to accelerate it. Put
differently, coordination failure problems work against successful industrialization, a
counterweight to the push for development. A big push may not always be needed, but it is
helpful to find ways to characterize cases in which it will be.

The Balanced Growth Theory

This theory was advocated mainly by Rosenstein-Rodan (1943), Ragnar NurKse (1953) and
Arthur Lewis (1954). But their view about balanced growth theory was different. To some
writers, balanced growth means investing in a lagging sector of the national economy or
industry so as to ensure that it catches up with others. To others, balanced growth implies that
investment takes place simultaneously in all sectors of the national economy. Still to
others, it implies the balanced development of agricultural and industrial sectors of
the economy. To this extent, balanced growth calls for maintaining the balance between the
different consumer and capital good industries. It also calls for ensuring balance between
agriculture and industry and between the domestic and export sectors of the national
economy. Additionally, it requires balance between social and economic overheads and
directly productive investment. Moreover, the economists in favor of the balanced growth
postulated the balance between supply side and demand side. The supply side consists of
simultaneous development of all interrelated sectors, i.e., intermediate goods, raw materials,
power, agriculture, transport, and consumer goods industries. The demand side comprises
provision of employment opportunities which increase income and thus demand of the
consumers. To sum up in the words of Lewis, ―in development Program all sectors of the
economy should grow simultaneously so as to keep a proper balance between industry and
agriculture and between production for home consumption and production for exports‖.
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Unbalance Growth
The theory of unbalanced growth is the opposite of the doctrine of balanced growth. The
dissatisfaction with the theoretical underpinnings of the balanced growth theory gave rise to a
new school of thought that of unbalanced growth which has an intellectual as well as a
practical appeal. The deliberate unbalancing of the economy in accordance with a pre-
designed strategy is the best way to achieve rapid economic development in the less
developed countries. Investments in strategically selected industries or sectors of the
economy, will lead to new investment opportunities and so pave the way for further
economic development. According to this theory investment should be made in selected
sectors rather than simultaneously in all sectors of the economy.
The international-dependence model
The dependency theory states that the dependence of LDCs on DCs is the main cause for
underdevelopment of the former. Definition: dependency is a situation in which the economy
of certain countries is conditioned by the development and expansion of another economy to
which the former is subjected. It is explained in the following characteristics:
E. Dependency a historical international process: - the present economic and socio-
political condition prevailing in LDCs is result of a historical international process.
F. Dependency on foreign capital: LDCs depend on DCs on foreign capital, the foreign
investors exploit LDCs by insisting on the choice of projects, making decisions on
pricing, supply of equipment‘s, knowhow, and personnel etc. The dependency on foreign
capital leads to a much higher outflow in the form of declared profits, royalties, transfer
of pricing, payment of principal and interest to foreign investors of DCs.
G. Technological dependence; LDCs use excessively capital intensive technologies
imported from DCs. These technologies are inappropriate to the production and
consumption of LDCs.
H. Trade and Unequal Exchange: LDCs export primary products with inelastic demand
and import manufactured goods. NB. Within the international dependency revolution,
there are three major streams of thought: the neocolonial dependence model, the false-
paradigm model, dualistic-development thesis.
Neocolonial dependence model: A model whose main proposition is that
underdevelopment exists in developing countries because of continuing exploitative
economic, political, and cultural policies of former colonial rulers toward less developed
countries.
False-paradigm model: The proposition that developing countries have failed to
develop because their development strategies (usually given to them by Western
economists) have been based on an incorrect model of development, one that, for
example, overstressed capital accumulation or market liberalization without giving due
consideration to needed social and institutional change. The false-paradigm model,
attribute underdevelopment to faulty and inappropriate advice provided by well-meaning
but often uninformed, biased, and ethnocentric international expert‖ advisers from
developed- country assistance agencies and multinational donor organizations. These
experts are said to offer complex but ultimately misleading models of development that
often lead to inappropriate or incorrect policies.
The Neoclassical Counterrevolution: The 1980s resurgence of neoclassical free-market
orientation toward development problems and policies, counter to the interventionist
dependence revolution of the 1970s. The central argument of the neoclassical
counterrevolution is that underdevelopment results from poor resource allocation due to

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 incorrect pricing policies and too much state intervention by overly active developing-
nation governments. the neoclassical counterrevolutionaries argue that the developing
world is underdeveloped not because of the predatory activities of the developed world
and the international agencies that it controls but rather because of the heavy hand of the
state and the corruption, inefficiency, and lack of economic incentives that permeate the
economies of developing nations. What is needed, therefore, is not a reform of the
international economic system, a restructuring of dualistic developing economies, an
increase in foreign aid, attempts to control population growth, or a more effective
development planning system.
Rather, it is simply a matter of promoting free markets and laissez-faire economics within
the context of permissive governments that allow the ―magic of the market place‖ and the
―invisible hand‖ of market prices to guide resource allocation and stimulate economic
development.
New growth theory: The theory that our unlimited wants may lead us to ever greater
productivity and perpetual economic growth. According to new growth theory, real GDP
per person grows because of the choices people make in the pursuit of profit. New growth
theory predicts that national growth rates depend on national incentives to save, invest,
accumulated human capital, and innovate. According to neo-classical theory, the low
capital-labor ratios of Third world countries promise exceptionally high rates of return on
investment. According to neoclassical theory, the low capital labor ratio of third world
country promise exceptional high rate of return on investment. The free market reforms
imposed on highly indebted countries by the World Bank and the international monetary
fund should thus have promoted higher investment, rising productivity, and improved
standard of living. Yet even after prescribed liberalization of trade and domestic markets,
many LDCs experienced little or no growth and failed to attract new foreign investment
or to halt the flight of domestic capital. The new growth theory (endogenous growth)
provides a theoretical framework for analyzing endogenous growth, persistent GNP
growth that is determined by the system governing the production process rather than by
forces outside that system.

CHAPTER FOUR
Economics of Growth, Capital, labor, and Technology
Three factors or components of economic growth are of prime importance in any society: 1.
capital accumulation, including all new investments in land, physical equipment, and human
resources, 2. growth in population and hence eventual growth in the labor force, and 3.
Technological progress.
d) What is Capital Accumulation?
Capital accumulation results when some proportion of present income is saved and invested
in order to augment future output and income. New factories, machinery, equipment, and
materials increase the physical capital stock of a nation (the total net real value of all
physically productive capital goods) and make it possible for expanded output levels to be
achieved. These directly productive investments are supplemented by investments in what is
known as social and economic infrastructure - roads, electricity, water and sanitation,
communications, and the like- which facilitates and integrates economic activities. Capital
accumulation may add new resources (e.g., the clearing of unused land) or upgrade the
quality of existing resources (e.g., irrigation, fertilizer, pesticides).
e) Population And Labor Force Growth
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Population growth, and the associated eventual increase in the labor force, has traditionally
been considered a positive factor in stimulating economic growth. A larger labor force means
more productive workers, and a large overall population increases the potential size of
domestic markets. However, it is questionable whether rapidly growing supplies of workers
in surplus-labor developing countries exert a positive or a negative influence on economic
progress. Obviously, it will depend on the ability of the economic system to absorb and
productively employ these added workers-an ability largely associated with the rate and kind
of capital accumulation and the availability of related factors, such as managerial and
administrative skills. Given your initial understanding of these first two fundamental
components of economic growth and disregarding technology, Let us see how they interact
via the production possibility curve to expand society‘s potential total output of all goods.
f) Technological Progress
Technological progress, for many economists is the most important source of economic
growth. In its simplest form, technological progress results from new and improved ways of
accomplishing traditional tasks such as growing crops, making clothing, or building a house.
There are three basic classifications of technological progress: neutral, laborsaving, and
capital-saving.
iv. Neutral Technological progress
In terms of production possibility analysis, a neutral technological change that, say, doubles
total output is conceptually equivalent to a doubling of all productive inputs. A neutral
technological progress allows producers to produce more with same capital labor ratio (do
not save relatively more of either input).
v. Labor saving Technological Progress
The technological progress uses more capital relative to labor. Computers, the Internet,
automated looms, high-speed electric drills these and many other kinds of modern machinery
and equipment can also be classified as product of labor-saving technological progress.
Technological progress over the last century has consisted largely of rapid advances in labor
saving technology is for producing everything from beans to bicycles to bridges.
vi. Capital-saving Technological Progress
The technological progress uses more labor relative to capital. Such progress is more efficient
(lower-cost) labor-intensive methods of production- for instance foot- operated bellows
pumps, and back mounted mechanical sprayers for small-scale agriculture. In the labor
abundant (capital- scarce), Developing countries, such as Ethiopia, capital saving
technological progress is what is needed most.

Chapter Five:
Inequality, Poverty and Development
Measurement of Income inequality
Economists usually like to distinguish between two principal measures of income distribution
for both analytic and quantitative purposes.
a. The personal or size distribution of income
b. The functional or distributive factor share distribution of income.
c) Size Distributions
The personal or size distribution of income is the measure most commonly used by
economists. It simply deals with individual persons or households and the total income they

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receive. The way in which that income was received is not considered. Personal distribution
of income (size distribution of income) The distribution of income according to size class of
persons, for example, the share of total income accruing to the poorest specific percentage or
the richest specific percentage of a population without regard to the sources of that income.
Economists and statisticians, therefore, like to arrange all individuals by ascending personal
incomes and then divided the total population in to distinct groups or sizes. A common
method is to divide the population in to successive quintiles (fifths) or deciles (tenths)
according to the ascending income levels and then determine what proportion of the total
national income is received by each income group.
Lorenz Curve
The Lorenz curve shows the actual quantitative relationship between the percentages of
income recipients and the percentage of the actual income they did in fact receive during, say,
a given year. The more the Lorenz line curves is away from the diagonal (perfect equality
line), the greater the degree of inequality represented. The extreme case of perfect inequality
( i.e. a situation in which one person receives all of the national income while ever body else
receives nothing) would be represented by the congruence of the Lorenz curve with the
bottom horizontal and right hand vertical axes. Because no country exhibits either perfect
equality or perfect inequality in its distribution of income, the Lorenz curves for different
countries will lie somewhere to the right of the diagonal The greater the degree of inequality,
the greater the bend and the closer to the bottom horizontal axis the Lorenz curve will be.
(See the Lorenz curve).
Gini Coefficient
A final and very convenient short hand summary measure of the relative degree of income
inequality in a country can be obtained by calculating the ratio of the area between the
diagonal and the Lorenz curve divided by the total area of the half square in which the curve
lies. Gini coefficients are aggregate inequality measures and can vary anywhere from 0
(perfect equality) to 1 (perfect inequality). Gini coefficients for countries with highly
unequal income distributions typically lies between 0.50 and 0.70 while for countries with
relatively equitable distributions, it is on the order of 0.20 to 0.35.
d) Functional Distribution
This one is sometimes referred as factor share distribution of income. It is the distribution of
income to factors of production without regard to the ownership of the factors. It explains the
share of total national income that each factor of production (land, labor and capital) receives.
Instead of looking at individuals as separate entities, the functional distribution inquiries into
the percentage that labor receives as a whole and compares this with the percentages of total
income distributed in the form of rent, interest, and profit (i.e. the returns to land and
financial and physical capital).
Measuring Poverty
Measuring Absolute Poverty
Absolute poverty: the situation of being unable or only barely able to meet the subsistence
essentials of food, clothing, and shelter. Extent of absolute poverty can be defined as the
number of people who are unable to command sufficient resources to satisfy basic needs.
They are counted as the total number living below a specified minimum level of real income
an international poverty line. The Absolute Poverty Headcount H simply adds the number of

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people whose income is below an agreed upon poverty line. The Headcount index H/N
divides this number by the population.
Poverty, Inequality, and Social Welfare
First, extreme income inequality leads to economic inefficiency. At any given average
income, the higher the inequality, the smaller the fraction of the population that qualifies for a
loan or other credit. Lack of collateral, low-income individuals cannot borrow money; they
generally cannot adequately educate their children or start and expand a business. Moreover,
with high inequality, the overall rate of saving in the economy tends to be lower, because the
highest rate of marginal savings is usually found among the middle classes.
The second reason to be concerned with inequality is that extreme income disparities
undermine social stability and solidarity. Also, high inequality strengthens the political power
of the rich and hence their economic bargaining power. Usually this power will be used to
encourage outcomes favorable to them. High inequality facilitates rent seeking, including
actions such as excessive lobbying, large political donations and bribery. When resources are
allocated to such rent-seeking behaviors, they are diverted from productive purposes that
could lead to faster growth. The poor try revolution while the rich try corruption and rent-
seeking to retain power.
Finally, extreme inequality is generally viewed as unfair. Would you vote for an income
distribution that was more equal or less equal than the one you see around you? If the degree
of equality had no effect on the level of income or rate of growth, most people would vote for
nearly perfect equality. Of course, if everyone had the same income no matter what, there
would be little incentive to work hard, gain skills, or innovate. As a result, most people vote
for some inequality of income outcomes, to the extent that these correspond to incentives for
hard work or innovation.
Growth versus Income Distribution
The debate about the relationship between economics distribution takes many forms. The key
arguments are the traditional argument and the counter argument.
a) The traditional Argument: Factor shares, saving and Economic growth.

Although much of economic analysis has been strangely silent on the relationship between
economic growth and the resulting distribution of income, a large body of theory in essence
asserts that highly unequal distributions are necessary conditions for generating rapid growth.
The basic economic argument to justify large income in equalities was that high personal and
corporate incomes were necessary conditions of saving, which made possible investment and
economic growth. If the rich save and invest significant portions of their incomes while the
poor spend all their income on consumption goods, and if GNP growth rates are directly
related to the proportion of national income saved, then apparently an economy characterized
by highly unequal distributions of income would save more and grow faster than one with a
more equitable distribution of income.
b) Counterargument
Certain degree of redistribution can enhance saving and push up growth rate. Which
argument to follow depends on the relationship between marginal saving rate and the level
income? Potentially we can have three types of marginal saving rate: Increasing marginal
saving rate, Decreasing marginal saving rate, and Constant marginal saving rate
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 If the marginal saving rate is increasing, increase in inequality reduces the volume of saving
in the economy. Similarly, if the marginal saving rate is decreasing, the reduction in
inequality increases the saving rate in the economy. In case of constant marginal saving,
inequality does not affect the rate of saving.
The Range of Policy Options: Some Basic Considerations
c) Areas of Intervention
We can identify four broad areas of possible government policy intervention, which
correspond to the following four major elements in the determination of a developing
economy's distribution of income:
Functional distribution-the returns to labor, land, and capital as determined by factor prices,
utilization levels, and the consequent shares of national income that accrue to the owners of
each factor. Change asset and skill inequality: the sources of income inequality. Land reform;
microcredit; basic education, Make taxes more progressive, and Poverty reduction programs:
direct transfers or subsidies for food, education, health, etc.
d) Policy options
Changing relative factor prices, Traditional-sector workers have very low incomes and
minimum-wage laws are seldom enforced, Artificially high modern-sector wages (due to
unions or laws) reduce the growth of the modern sector, condemning more people to poverty
and exclusion, Market-determined wages (which would be lower) in the modern sector would
increase employment and incomes for the poor, and Market-determined cost of capital (which
would be higher) would encourage firms to hire workers rather than buy capital.
 Transfer payments and public provision of goods and services
Make sure it‘s targeted to the poor, Prevent the poor from becoming dependent on it … but
encourage appropriate risk taking, Discourage switching from work to program, and Avoid
resentment by nearly-poor-but-not-enough who are working.
 ―workfare‖ is better than welfare if it
Does not undermine incentives for acquiring human capital needed for private sector jobs,
Increases net benefits – including externalities, Is difficult to identify the needy without work
requirement, There are relatively few poor people, and There less social stigma / political
resentment from workfare. The needs for a ‗package‘ of policies eliminate price distortions:
more efficiency, more employment and less poverty, Structural change in asset ownership
and Progressive taxes and transfers; safety net.

Development Economics II
Chapter one
2. Population Growth and Economic Development: Causes, Consequences, and
Controversies
2.1. The Basic Issue: Population Growth and Quality of Life
Every year, more than 75 million people are being added to the world‘s population.
Almost all of this net population increase 97% is in developing countries. Increases of
such magnitude are unprecedented. But the problem of population growth is not simply a
problem of numbers. It is a problem of human welfare and of development. Rapid population
growth can have serious consequences for the well- being of all of humanity.

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 2.2.The Hidden Momentum of Population Growth
The phenomenon population continues to increase, even after a fall in birth rates, because the
large existing youthful population expands the population‘s base of potential parents.
– High birth rates cannot be altered overnight and Age structure of developing country
populations

2.3.The Demographic Transition

The demographic transition is a process of change from a situation with high mortality and
fertility (and constant population), to a situation with low mortality and fertility. The process
is characterized by an initial reduction in mortality rates (increase in life expectancy),
followed with some delay by a reduction in fertility rates. In the interval between the
mortality reductions and the fertility reductions, population tends to experience accelerated
growth (given the increased rate of natural growth). All countries that ultimately achieved a
high level of economic development went through the demographic transition. Therefore, it
is usually thought that the demographic transition is a necessary condition for the
onset or beginning of the process of economic development.
Stage I: High birth rates and death rates, Stage II: Continued high birthrates, declining death
rates, and Stage III: Falling birthrates and death rates eventually stabilizing.
2.4. The Causes of High Fertility in Developing Countries: The Malthusian and
Household Models
The Malthusian Population Trap: Thomas R. Malthus believed that population would expand
as long as food supply allowed. Assumption that the ―passion between the sexes‖ would lead
to increased fertility whenever conditions allowed for it (any improvements in living standard
(due, for example, to good weather) would end up being reflected in a larger population).
Economically, it is as if he assumed that number of children was a ―normal good‖: any
increase in income would be reflected in parents having more children. So he also assumed
that any increase in population would take place at the expenses of living standards. If
population increased for some exogenous reason, some catastrophe was bound to
happen, so that initial level of living standards would end up being restored. Famines, wars,
and epidemics would be the mode of operation of Malthus‘s ―checks‖ This is the classic
Malthusian idea that population tends to grow at a geometric rate, while food supply tends to
grow at an arithmetic rate. In the long run, there‘s not enough food available, and
―positive checks‖ are needed to equilibrate population and food supply.
2.5.The Microeconomic Household Theory of Fertility
The Demand for Children in Developing Countries: First two or three as ―consumer goods‖,
Additional children as ―investment goods‖, Work on family farm, microenterprise, and Old
age security motivation. In the application of this theory to fertility analysis, children are
considered as a special kind of consumption (and in developing countries, particularly low
income countries, investment) good so that fertility becomes a rational economic response to
the consumer‘s (families) demand for children relative to other goods. The usual income and
substitution effects are assumed to apply If other factors are held constant, the desired
number of children can be expected to vary directly with household income, (this direct
relationship may not hold for poor societies; it depends on the strength of demand for
children relative to other consumer goods and to the sources of increased income, such as
female employment), inversely with the price (cost) of children, and inversely with the
strength of tastes for other goods relative to children.

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Some empirical evidence and Implications
Fertility lower if raise women‘s education, role, and status, more female nonagricultural wage
employment, rise in family income levels, reduction in infant mortality, development of old-
age and social security, and expanded schooling opportunities.
2.6. The Consequences of High Fertility: Some Conflicting Perspectives
Population growth: ―It‘s Not a Real Problem‖ The real problem is not population growth but
the following, underdevelopment, world resource depletion and environmental destruction,
population Distribution, and subordination of women. Overpopulation is a Deliberately
Contrived False Issue and population Growth is a Desirable Phenomenon.
―Population Growth Is a Real Problem‖ Extremist arguments: Unrestrained population
increase is seen as the major crisis facing humankind today. It is regarded as the principal
cause of poverty, low levels of living, malnutrition, ill health, environmental degradation, and
a wide array of other social problems. Theoretical arguments: Population growth is
believed to retard the prospects for a better life for the already born by reducing savings rates
at the household and national levels. This in turn further reduces the prospects for any
improvement in the levels of living of the existing generation and helps transmit poverty to
future generations of low-income families.
Chapter Two
3. Human Capital: Education and Health in Economic Development
2.5. The Central Roles of Education and Health
Education plays a key role in the ability of a developing country to absorb modern
technology and to develop the capacity for self-sustaining growth and development.
Moreover, health is a prerequisite for increases in productivity, and successful education
relies on adequate health as well. Thus, health and education are also important components
of growth and development. Their dual role as both inputs and outputs gives health and
education their central importance in economic development.
2.6. Investing in Health and Education: The Human Capital Approach
The analysis of investments in health and education is unified in the human capital approach.
Human capital is the term economists often use for education, health, and other human
capacities that can raise productivity when increased. Initial investments in health or
education lead to a stream of higher future income. The present discounted value of this
stream of future income is compared to the costs of the investment. Private returns to
education are high, and may be higher than social returns.
2.7. Educational Systems and Development
Educational supply and demand: the relationship between employment opportunities and
educational demands.
Demand for Education
Educated students have the prospect of earning significantly more income than uneducated
ones through future employment in the modern sector (the family's private educational
benefits). The educational costs, both direct and indirect, that a student or family must bear.
The amount of education demanded is thus in reality a derived demand for high-wage
employment opportunities in the modern sector.
Determinants of this derived demand

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The wage or income differential, the probability of success in finding modern-sector
employment, the direct private costs of education, and the indirect or opportunity costs of
education
Supply side
On the supply side, the quantity of school places at the primary, secondary, and university
levels is determined largely by political processes, often unrelated to economic criteria.
Social versus private benefits and costs
Typically in developing countries, the social costs of education increase rapidly as students
climb the educational ladder. The private costs of education (those borne by students
themselves) increase more slowly or may even decline. This widening gap between social
and private costs provides an even greater stimulus to the demand for higher education than it
does for education at lower levels. But educational opportunities can be accommodated to
these distorted demands only at full social cost.
Education, Inequality, and Poverty
Studies have demonstrated that contrary to what might have been assumed, the educational
systems of many developing nations sometimes act to increase rather than to decrease income
inequalities. The basic reason for this perverse effect of formal education on income
distribution is the positive correlation between level of education and level of lifetime
earnings.
2.8.The Gender Gap: Women and Education
Young females receive less education than young males in nearly every LDC. Closing this
educational gender gap is economically desirable because: The social rate of return on
women‘s education is higher than that of men in developing countries (why?). Education for
women increases productivity lowers fertility; educated mothers have a multiplier impact on
future generations; and Education can break the vicious cycle of poverty and inadequate
schooling for women.
CHAPTER THREE
3. Rural-urban interaction, migration, and unemployment
3.1.Urbanization: Trends and Projections
The United Nations projects that in 2025, over 4.1 billion, or 80%, of the urban dwellers of
the world will reside in less developed regions. A central question related to the
unprecedented size of these urban agglomerations is how these LDC cities will cope
economically, environmentally, and politically-with such acute concentrations of people.
While it is true that cities offer the cost-reducing advantages of agglomeration economies and
Economies of scale and proximity as well as numerous economic and social externalities
(e.g., skilled workers, cheap transport, social and cultural amenities), the social costs of a
progressive overloading of housing and social services increased crime, pollution, and
congestion, tend gradually to outweigh these historical urban advantages.
3.2. The Role of Cities and The Urban Gigantism Problem
To a large degree, cities are formed because they provide cost advantages to producers and
consumers through what are called agglomeration economies. Agglomeration economies
Cost reducing advantages to producers and consumers from location in cities and towns,
which take the forms of urbanization economies and localization economies. Urbanization
economies: Agglomeration effects associated with the general growth of a concentrated
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geographic region. Localization economies: Agglomeration effects captured by particular
sectors of the economy, such as finance or autos, as they grow within an area.
The Urban Gigantism Problem
In the case of developing countries, the main transportation routes are often a legacy of
colonialism.
Theorists of the dependence school have compared colonial transportation networks to
drainage systems, emphasizing ease of extraction of the country‘s natural resources. In many
cases, the capital city will be located near the outlet of this system on the seacoast. This type
of transportation system is also called a ―hub-and-spoke system,‖ which is especially visible
when the capital city is located in the interior of the country. Many nations inherited a hub-
and-spoke system from colonial times, including many in Africa and Latin America, which
also facilitated movement of troops from the capital to the outlying towns to suppress revolts.
First City Bias
A form of urban bias that has often caused considerable distortions might be termed first-city
bias. The country‘s largest or ―first-place‖ city receives a disproportionately large share of
public investment and incentives for private investment in relation to the country‘s second-
largest city and other smaller cities. As a result, the first city receives a disproportionately and
inefficiently large share of population and economic activity. Some other developing
countries have remarkably outsized first cities, notably Thailand, where Bangkok has a
population about 20 times the size of the second city.
Causes of Urban Gigantism
Why first cities often swelled to such a large multiple of second cities in developing
countries? Overall, urban gigantism probably results from a combination of a hub-and-spoke
transportation system and the location of the political capital in the largest city. This is further
reinforced by a political culture of rent seeking and the capital market failures that make the
creation of new urban centers a task that markets cannot complete. Under Import substitution
industrialization, with a high level of protection, there is much less international trade, and
population and economic activity have an incentive to concentrate in a single city, largely to
avoid transportation costs.
3.3. Economic Model of Rural-Urban Migration
Michael P. Todaro has attempted to develop a theory of rural-urban migration to explain the
apparently paradoxical relationship of accelerated rural-urban migration in the context of
rising urban unemployment.
Starting from the assumption that migration is primarily an economic phenomenon, which for
the individual migrant can be a quite rational decision. Despite the existence of urban
unemployment, the Todaro model postulates that migration proceeds in response to urban-
rural differences in expected income rather than actual earnings. The fundamental premise is
that migrants consider the various labor market opportunities available to them in the rural
and urban sectors and choose the one that maximizes their expected gains from migration.
Expected gains are measured by the difference in real incomes between rural and urban work
and the probability of a new migrant's obtaining an urban job. The theory assumes that
members of the labor force compare their expected incomes for a given time horizon in the
urban sector (the difference between returns and costs of migration) with prevailing average
rural incomes and migrate if the former exceeds the latter.

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The Todaro migration model has four basic characteristics:
6. Migration is stimulated primarily by rational economic considerations of relative benefits
and costs, mostly financial but also psychological.
7. The decision to migrate depends on expected rather than actual urban rural real-wage
differentials where the expected differential is determined by the interaction of two
variables, the actual urban-rural wage differential and the probability of successfully
obtaining employment in the urban sector
8. The probability of obtaining an urban job is directly related to the urban employment rate
and thus inversely related to the urban unemployment rate.
9. Migration rates in excess of urban job opportunity growth rates are not only possible but
also rational and even likely in the face of wide urban rural expected income differentials.
10. High rates of urban unemployment are therefore inevitable outcomes of the serious
imbalance of economic opportunities between urban and rural areas in most
underdeveloped countries.
Lewis Development Model
Lewis two-sector model:- A theory of development in which surplus labor from the
traditional agricultural sector is transferred to the modern industrial sector, the growth of
which absorbs the surplus labor, promotes industrialization, and stimulates sustained
development.
7. The underdeveloped economy consists of two sectors: a traditional, overpopulated rural
subsistence sector characterized by zero marginal labor productivity a situation that
permits Lewis to classify this as surplus labor in the sense that it can be with- drawn from
the traditional agricultural sector without any loss of output and a high-productivity
modern urban industrial sector into which labor from the subsistence sector is gradually
transferred. Surplus labor: - The excess supply of labor over and above the quantity
demanded at the going free-market wage rate. It refers to the portion of the rural labor
force whose marginal productivity is zero or negative.
8. The assumption of the rate of labor transfer and employment creation in the modern
sector is proportional to the rate of modern sector capital accumulation.
9. The assumption of surplus labor exists in rural areas while there is full employment in the
urban areas.
10. The assumption is the notion of a competitive modern sector labor market that guarantees
the continued existence of constant real urban wages up to the point where the supply of
rural surplus labor is exhausted.
11. The speed with which industrial expansion occurs is determined by the rate of industrial
investment and capital accumulation in the modern sector.
12. The laws of diminishing return to scale in the modern industrial sector.
Chapter five
10.1. Role of foreign trade in development
The role of foreign trade can be judged by the following faces:
Foreign trade and economic development
Foreign trade plays very important role in the economic development of any country.
Economic development of a country depends of foreign trade.
Foreign exchange earning
Foreign trade provides foreign exchange which can be used to remove the poverty and other
productive purposes. Some country also exports a lot of agricultural product to other
countries and imports the capital goods from other countries.

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Market expansion
The demand plays very important role in increasing the production of any country. The
foreign trade expands the market and encourages the producers. So it is necessary that we
should sell our product in other countries.
Increase in investment
Foreign trade encourages the investor to increase the investment to produce more goods. So
the rate of investment increases.
Foreign investment
Besides the local investment, foreign trade provides incentives for the foreign investors to
invest in those countries where there is a shortage of investment.
Increase in national income
Foreign trade increases the scale of production and national income of the country. To meet
the foreign demand we increase the production on large scale so GNP also increases.
Decrease in unemployment
With the rise in the demand of goods domestic resources are fully utilized and it increases the
rate of development in the country and reduces the unemployment in the world.
Price stability
Foreign trade helps to bring stability in price level. All those goods which are in shortage and
prices are increasing can be imported and those goods which are surplus can be exported.
There by stopping fluctuation in prices.
Specialization
There is a difference in the quality and quantity of various factors of production in different
countries. Each country adopts the specialization in the production of those commodities, in
which it has comparative advantage. So all trading countries enjoy profit through
international trade.
Remove monopolies
Foreign trade also discourages the monopolies. Where every monopolist increases the prices,
government allows the import of goods to reduce the prices in the country.
Removal of food shortage
We always face the food shortage problem. To remove this food shortage we imported the
wheat many times. So due to foreign trade we are solving this problem for many years.
Agricultural development
Agricultural development is the back bone in our economy. Foreign trade has played very
important role for the development of our agriculture. Every year we export coffee, flower,
fruits and vegetables to other countries. The export of goods makes our farmer more
prosperous. It inspires the spirit of development in them.
Import of consumer goods
We import the various consumer goods from other countries, which are not produced inside
the country. Today the shortage of any commodity can be removed through international
trade.
To improve quality of local products
Foreign trade helps to improve quality of local products and extends market through changes
in demand and supply as foreign trade can create competition with the rest of the world.
Competition with foreign producers
We can compete with the foreign producers in foreign trade so it improves the quality and
reduces the cost of production. It is also an advantage of foreign trade.
Useful for the world peace
Today all the countries are tied in trade relations with each other. Foreign trade also
contributes to peace and prosperity in the world.
Import of capital goods and technology
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The inflow of capital goods and technology in the less developed countries has increased the
rate of economic development, and this is due to foreign trade.
Import substitution
These countries not only produce import substitute, but also reduce deficit in balance of
payment of their countries.
Dissemination of knowledge
Foreign trade is also responsible for dissemination of knowledge and learning from
developed countries to under developed countries.
Factors productivity
Through foreign trade the productivity of labour and capital and organization increases.
Demand make them mobile on national as well as international level which helps
underdeveloped countries to develop and maintain a high level of growth of developed
countries.
10.2. Demand Elasticities and Export Earning Instability
In the case of primary products, the income elasticity of demand is relatively low. The
percentage increase in quantity of primary agricultural products and most raw materials
demanded by importers (mostly rich nations) will rise by less than the percentage increase in
their GNIs. Manufactured goods, income elasticity is relatively high. Moreover, the price
elasticity of demand for (and supply of) primary commodities also tends to be quite low. Any
shifts in demand or supply curves can cause large and volatile price fluctuations. Together
these two elasticity phenomena contribute to what has come to be known as export earnings
instability, which has been shown to lead to lower and less predictable rates of economic
growth. But, If the demand for exports is elastic, then a change in the average price of exports
will lead to a greater proportional change in the demand for them. This would be favorable to
a country where export prices were falling, since export demand would rise by proportionally
more than the prices fell leading to an increase in export revenue.
10.3. Terms of trade
Economists have a special name for the relationship or ratio between the price of a typical
unit of exports and the price of a typical unit of imports. This relationship is called the
commodity terms of trade, and it is expressed as Px/Pm, where Px and Pm represent the
export and import price indexes. The commodity terms of trade are said to deteriorate for a
country if Px/Pm falls, that is, if export prices decline relative to import prices, even though
both may rise. The main theory for the declining commodity terms of trade is known as the
Prebisch-Singer hypothesis.
10.4. The trade policy debate: Export promotion industrialization versus Import
substitution Industrialization
Two basic strategies regarding trade have been adopted through history: Import substitution:
Replacement of imported goods by goods produced domestically; via protection of domestic
markets against imports. Outward-looking trade policies (export-oriented strategies): Shift
focus from production for domestic markets to production for export to foreign markets; via
policies trying to promote and support exports.
Import substitution
The basic idea is the following: There may be high initial costs of local production. So, in
order to make it profitable for local entrepreneurs to invest, protective barriers are raised to
reduce the influx of imports. This increases the market for potential local producers and
increases their profitability. How are these protective ―barriers‖ erected? The government
uses instruments that it has available. These usually include tariffs or quotas on imports,
sometimes ban on imports of certain goods, subsidies to the inputs of the local producers.
This idea that industries should be protected in the first stages of their development is called
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the ―Infant Industry‖ argument, and it‘s associated with German economist Friedrich Liszt.
New industry in a country has to compete against firms abroad, which have long experience
with the same production technology, with marketing strategies, distribution channels, etc. So
these new national industries needs time to ―learn‖ the best way to operate on all these
dimensions.
Trade Policy Instruments
Protective Tariffs
A protective tariff works like a tax on imported goods: if you‘re an importer, you have to pay
a fraction of the imported good price as a tax to the government. The basic effect of a tariff is
to raise the domestic price above the world price. The tariff will increase domestic producer‘s
welfare because it‘ll allow them to sell more at a higher price. It will reduce domestic
consumers‘ welfare because they‘ll consume less at a higher price.
Import Quotas: Quotas are quantitative restrictions: the government fixes the maximum
quantity of a good that can be imported. Subsidies: Governments can offer subsidies to
domestic firms in order to increase their profitability and, therefore, ―protect‖ national firms.
Exchange Rate Management: Governments sometimes try to control the exchange rate to
affect the relative prices of tradable and, therefore, affect amount of imports and exports.
Outward-Looking Strategies
Shift the focus from import substitution and domestic markets towards manufacturing for
exports to foreign markets. In this strategy, tariffs and quotas should be reduced to a
minimum, and prices should move closer to world prices. Also, governments should set up
institutions to help promote exports: duty exemption systems, export processing zones,
infrastructure development (ports, roads, energy supply), export subsidies, etc.
Advantages:
Economies of scale and specialization: By concentrating on export markets, scale of
operation can be larger (not restricted to domestic market) take advantage of gains from
learning by doing and allows industry to overcome fixed costs. Foreign exchange: Exports
generate foreign exchange that may be necessary to pay for imports of raw material and
capital goods (great limitation in the import substitution strategy). Enhanced capacity to
import capital goods + exposure to competition from world markets generates conditions and
incentives for domestic firms to keep up with technological advances in the rest of the world

Necessary conditions for a successful exports-oriented strategy:

1st: Macroeconomic stability: A stable economic environment, with moderate inflation and
stable exchange rate (at market-determined level); economic policy making not strongly
affected by political interests, rent-seeking, or corruption
2nd: Infrastructure: Development of adequate infrastructure (roads, railways, ports, energy
supply, and telecommunications.
3rd: Educated labor force: Development of adequate education and training institutions, in
order to provide workforce the relevant set of skills.
4th: Access of exporters to capital goods and raw materials at world prices: This can be
achieved via an open economy (no tariffs or quotas); or via Export Processing Zones (EPZ‘s),

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which are areas where exporters have access to duty-free imports of capital and raw
materials, and adequate infrastructure (duty exemption systems do a similar job, but are not
geographically defined)
5th: Flexible factor markets: Well-functioning labor and capital markets, where labor and
capital can move freely, and their prices are not controlled.
10.5. Balance of Payments and Macroeconomic Stabilization
Balance of payments (BOP) accounts are an accounting record of all monetary transactions
between a country and the rest of the world. These transactions include payments for the
country's exports and imports of goods & services, financial capital, and financial transfers. A
country has to deal with other countries in respect of 3 items:- Visible items which include all
types of physical goods exported and imported. Invisible items which include all those
services whose export and import are not visible. e.g. transport services, medical services etc.
Capital transfers which are concerned with capital receipts and capital payment.
Components of BOP
4. Current Account Balance: BOP on current account is a statement of actual receipts and
payments in short period. It includes the value of export and imports of both visible and
invisible goods. There can be either surplus or deficit in current account. The current
account includes:- export & import of services, interests, profits, dividends and
unilateral receipts/payments from/to abroad.
5. Capital Account Balance: It is difference between the receipts and payments on
account of capital account. It refers to all financial transactions. The capital account
involves inflows and outflows relating to investments, short term borrowings/lending,
and medium term to long term borrowing/lending. There can be surplus or deficit in
capital account. It includes: - private foreign loan flow, movement in banking capital,
official capital transactions, reserves, gold movement etc.
6. Overall BOP: Total of a country‘s current and capital account is reflected in overall
Balance of payments.
Causes of Disequilibrium
Natural causes – e.g. floods, earthquake etc.; Economic causes – e.g. Cyclical Fluctuations,
Inflation, Demonstration Effect etc; Political causes – e.g. international relation, political
instability, etc and Social factors – e.g. change in taste and preferences etc.
Macroeconomic Stabilization
How to correct the Balance of Payment?
1. Monetary measures
⇒ Exchange Depreciation - Exchange depreciation means decline in the rate of exchange of
domestic currency in terms of foreign currency.
⇒ Devaluation - Devaluation refers to deliberate attempt made by monetary authorities to
bring down the value of home currency against foreign currency.
2. Non-Monetary Measures
⇒ Export Promotion: The government can adopt export promotion measures to correct
disequilibrium in the balance of payments. This includes tax concessions to exporters,
marketing facilities, credit and incentives to exporters, etc.

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⇒ Quotas: Under the quota system, the government may fix and permit the maximum
quantity or value of a commodity to be imported during a given period.
⇒ Tariffs: Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices
of imports would increase to the extent of tariff.
CHAPTER SIX
Foreign Aid, Debt, Financial Reform and Development
Foreign aid can be defined as the international transfer of public funds in the form of loans or
grants either directly from one government to another (bilateral assistance) or indirectly
through the vehicle of a multilateral assistance agency such as the World Bank. However, we
should not include all transfers of capital to developing countries, particularly the capital
flows of private foreign investors. Private flows represent normal commercial transactions,
prompted by commercial considerations of profits and rates of return, and therefore should
not be viewed as foreign aid. Commercial flows of private capital are not a form of foreign
assistance, even though they may benefit the developing country in which they take place.
Economists have defined foreign aid as any flow of capital to a developing country that meets
two criteria: 1. Its objective should be non-commercial from the point of view of the donor,
and 2 It should be characterized by concessional terms; that is, the interest rate and repayment
period for borrowed capital should be softer (less stringent) than commercial terms.
Concessional terms: terms for the extension of credit that is more favorable to the borrower
than those available through standard financial markets. Donor-country governments give aid
because it is in their political, strategic, or economic self-interest to do so. Some development
assistance may be motivated by moral and humanitarian desires to assist the less fortunate
(emergency food relief and medical programs). We focus here on the foreign-aid motivations
of donor nations in two broad but often interrelated categories: political and economic.
Economic
⇒ Assist with economic development and technology transfer ⇒ help in case of emergency
(e.g., natural disasters)
⇒ saving gap: The excess of domestic investment opportunities over domestic savings,
causing investments to be limited by the available foreign exchange i.e. causing economic
growth. So, external assistance is also assumed to facilitate and accelerate the process of
development by generating additional domestic savings as a result of the higher growth rates
that it is presumed to induce.
⇒ Foreign-exchange gap: The shortfall that results when the planned trade deficit exceeds the
value of capital inflows, causing output growth to be limited by the available foreign
exchange for capital goods imports i.e. aid improving the BOP.
⇒ Technology gap: facilitating industrialization given absorptive capacity limitation
⇒ Technical assistance: Financial assistance needs to be supplemented by technical
assistance in the form of high-level worker transfers to ensure that aid funds are used most
efficiently to generate economic growth.
Political
⇒ Use of aid to support regimes considered to be ‗friendly‘ to the interests of the donor
governments
⇒ Promote ―national security‖ by shifting FA from one country or region to another
Humanitarian and moral motives
⇒ Short term emergency assistance
⇒ Long-term development assistance on debt relief and poverty alleviation
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Factors limiting the effectiveness of aid
1. Tied aid
⇒ Tied aid. In the context of bilateral aid: recipients must spend part of the borrowed funds
on good and service from the donor country. Higher import costs and Purchase of
inappropriate capital intensive technologies and development and use of skills inappropriate
to local developing country conditions
2. Conditional aid
Conditional aid: Donors impose conditions to be met by recipients to ensure that funds are
used effectively. Policies towards market orientation, acceptance of projects decided by
donors, and detailed reporting on spending, timetables, and priorities.
Problems with conditional aid: The preferences of the government or population group are
not considered. Policy prescriptions by donors may be incorrect: May not fit in with the
government‘s priorities and May undermine government‘s authority.
3. Aid volatility and unpredictability: Makes it difficult for recipient governments to
implement policies that depend on aid funds
4. Uncoordinated donors: Uncoordinated donors and inefficiencies in the use of aid resources
5. Aid substitutes rather than complements domestic resources
Aid substitutes rather than complements domestic resources and no enough effort to increase
revenues through taxation.
6. Aid may not reach those most in need. Aid resources are not allocated on the basis of the
greatest need for poverty alleviation:
Bilateral donors guided by political and strategic interests. Recipient country‘s gov may not
be committed to poverty alleviation or lack expertise to design a poverty alleviation strategy.
7. Aid associated with corruption
⇒ Misuse of aid funds by recipient countries

Foreign debt may be defined as the amount of money that a country‘s residents, both public
and private, owe to the rest of the world. It is important to distinguish between gross and net
foreign debt. Gross foreign debt is the total amount borrowed from non-residents. Net foreign
debt is gross foreign debt minus resident‘s lending to overseas. Many people view foreign
debt as a disadvantage for a country, although most countries do have a foreign debt.
However, foreign debt can be an advantage since it can provide an increase in a nation‘s
productive capacity, output, employment and living standards.
A serious problem can arise, however, when;
1 The accumulated debt becomes very large.
2 The sources of foreign capital switch from long-term ―official flows‖ on fixed, concessional
terms to short-term and at higher interest rate.
3 The country begins to experience severe balance of payments problems.
4 A global recession or some other external shock.
5 A loss in confidence in the ability of a developing country to repay.
6 A substantial flight of capital is precipitated by local residents.
DEBT SERVICING
Repaying foreign debt requires payment of the original sum borrowed, plus interest on that
debt. This is known as debt servicing.
Foreign debt can be seen as: A nation‘s imports and income paid to overseas residents is
greater than the value of exports and income received. National expenditure exceeding
national income, i.e. a nation spending more than it earns. The difference between national
investment and national savings: If a country does not have sufficient domestic savings, it
must borrow to finance its investment which must come from overseas.
CONSEQUENCES OF FOREIGN DEBT
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Foreign debt has several consequences for a country: 1 Falling credit ratings – this will
increase the interest rate that the country will have to pay on future borrowings since lenders
perceive a greater lending risk. 2 The increased interest payments lower the country‘s
standard of living as more income is diverted from consumption
REDUCING FOREIGN DEBT
There are several ways to reduce a country‘s foreign debt:
i) Increasing international competitiveness (microeconomic reform). Growth in exports will
reduce the CAD and hence foreign debt. ii) Increasing the savings pool - this will reduce the
borrowings required to fund investment iii) Monetary policy to maintain low inflation rates
will improve export competitiveness – this will also preserve the real purchasing power of
savings and will act to improve the level of domestic savings. iv) Use of fiscal and monetary
policy to reduce aggregate demand-this will discourage import demand which contributes to
foreign debt.

There are two main types of foreign investments: Portfolio investment and direct investments
Portfolio investments are purely financial assets, such as bonds and stocks, denominated and
expressed in a national currency. They take place primarily through financial institutions
(banks and investment funds).
Direct investments are real investments in factories, capital goods, land, and inventories
where both capital and management are involved and the investor retains control over use of
the invested capital.
FDI Debate: Pros
⇒ Foreign Direct Investment fills the
1 Saving gap: causing economic growth
2 Foreign-exchange gap: improving the BOP
3 Tax revenue gap: raising funds for public spending
4 Management gap: improving entrepreneurship
5 Technology gap: facilitating industrialization
FDI Debate: Cons
⇒ Multi-National Corporations
Don‘t reinvest their profit
 Return profits to their headquarters through transfer pricing
 Create income for semi-skilled labor with low saving propensities
 Deteriorate current account through importation of capital goods and intermediate
products
 Deteriorate capital account through outflow of profits
 Receive investment tax credits and are exempt from tariffs
 Hinder development of domestic managerial skills
 Gain monopoly power
 Reinforce dualism, increase income inequality, and induce R-U migration Influence local
politics and support ―friendly‖ governments.

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